12/07/2017

Week 3 Lecture

Decision Making 1
Reading: Chapter 19 (pp.844-865; 869-872)

Decision Making

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The management accountant’s role in

decision making
To provide relevant information to managers and teams who make the
decisions

• Tactical decisions
- Resource commitments
- Quickly changed or reversed

• Long-term decisions
- More strategic
- Movements in capacity-related resources
- More difficult to reverse

A model of the decision-making process

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Characteristics of relevant information

• Different under competing courses of action

- Costs and benefits that are the same

• Relates to the future

- Consequences of decisions
- Sunk costs are ignored
- Prediction of future costs may be based on past data

Example 1

A young lady was driving to Parramatta one day when the engine on her car blew. She
subsequently paid $1500 for a reconditioned engine to be installed in her 1988 Toyota
Corolla. A few months later the lady was considering purchasing a new car but was
reluctant to make this decision as she claimed ‘I have just spent $1500 on a reconditioned
engine’. Critically evaluate the logic of this statement and discuss the relevant costs in
deciding whether or not to purchase a new car.

What are the future costs / benefits to consider in making this decision?

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Identifying relevant costs and benefits:

terminology

Incremental revenue
- Results from choosing one course of action over another
Incremental costs
- Costs that arise from choosing one course of action over another
Out-of-pocket costs
- Incurred if a particular course of action is selected
Sunk costs
- Already incurred and irrelevant for future decisions

Identifying relevant costs and benefits:

terminology

Opportunity costs
- The potential benefit given up when the choice of one action precludes a
different action
Avoidable costs
- Costs that will not be incurred in the future if a particular decision is made
Unavoidable costs
- Costs that will continue to be incurred no matter which decision
alternative is chosen
- Irrelevant to the decision

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Accept/Reject Special Order

Example 2
SunGun Inc. produces 100,000 blenders per month, which is 80% of
capacity. Variable manufacturing costs are $8 per unit and fixed costs are
$400,000. The blenders are sold in the market for $20 each. Mexico Co.
has approached SunGun Inc. and offered to purchase 2000 blenders at
$11 each. Do we take up the offer?

Accept/Reject Special Order

Why did we ignore the fixed costs?

1. They do not change in the short-run.

2. Unless the total capacity changes fixed costs won’t change.

Therefore, we should accept the special order as,

Incremental revenues > Incremental costs.

You also need to consider qualitative factors.

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Accept/Reject Special Order

How does the analysis change if the plant had no excess capacity?
We would have to include opportunity costs in the calculations.

The Make or Buy Decision

Example 3
 Essex manufactures part 4A that is
currently used in one of its products.
 The cost per unit of this part is:

Direct materials $ 9
Direct labour 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Total cost per unit $ 30

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The Make or Buy Decision

 The special equipment used to manufacture part 4A

has no resale value.
 The total amount of general factory overhead, which
is allocated on the basis of direct labor hours, would
be unaffected by this decision.
 The $30 total cost per unit is based on 20,000 parts
produced each year. The supervisor’s salary can be
avoided if 4A was purchased.
 An outside supplier has offered to provide the
20,000 parts at a cost of $25 per part
 Should Essex accept the supplier’s offer?

The Make or Buy Decision

We need to look at the relevant costs, which in

this case are the avoidable costs.

The unavoidable costs are irrelevant as they will

be incurred regardless of which course of action
is taken, i.e. make or buy.

The irrelevant costs are thus the factory

overhead and the special equipment used to
manufacture 4A.

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The Make or Buy Decision

Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25

Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of equip. 3
Supervisor's salary 2
General factory overhead 10
Total cost $ 30

The Make or Buy Decision

Let us now assume that the we take the buy option and the factory space
that was being used to produce 4A can be used to produce a new product
line called 5A. The estimated contribution margin from product 5A is
$162,000.

How does this affect the make/buy decision?

The contribution from 5A represents an opportunity cost to the business.

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The Make or Buy Decision

The calculation including the opportunity costs is:

Total cost of ‘make’ option =
PLUS: OC of not producing 5A =
Total: =
Total cost of the ‘buy’ option =

Add/Delete Product or Department

Example 4
Martina Company manufactures tennis racquets in three
models: Pro, Master, and Champ. Pro and Master are
profitable lines, whereas Champ operates at a loss. The
fixed expenses are allocated to the departments based on
machine hours. Condensed income statement data are:

Pro Master Champ Total

Sales $800,000 $300,000 $100,000 $1,200,000
Variable expenses 520,000 210,000 90,000 820,000
Contribution margin 280,000 90,000 10,000 380,000
Fixed expenses 80,000 50,000 30,000 160,000
Net income $200,000 $ 40,000 $(20,000) $ 220,000

Question:
Should the Champ segment be eliminated?

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Add/Delete Product or Service

We need to analyse the avoidable costs that are relevant to this decision.

Add/Delete Product or Department

Alternatively we can see the total effect on the company is as

follows:

Pro Master Champ Total

Sales $800,000 $300,000
Variable expenses 520,000 210,000
Contribution margin 280,000 90,000
Fixed expenses 80,000 50,000
Net income $200,000 $ 40,000

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Incentives for decision makers

Managers typically make decisions that will maximise their reported

performance and rewards

Cost systems may be designed to explicitly encourage certain biases in

decision making

To encourage managers and employees to make certain decisions,

systems must be designed with this in mind

Pitfalls to avoid in using accounting data

for decisions

• Ignore sunk costs

• Beware of using unitised fixed costs in decision making

• Beware of allocated fixed costs, but focus on identifying the avoidable cos

• Pay special attention to identifying and including opportunity costs in a

• decision analysis

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