Cost Accounting Chapter 11

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CHAPTER 11

Decision Making
and
Relevant Information

Decision Models
A decision model is a formal method of

making a choice, often involving both


quantitative and qualitative analyses
Managers often use some variation of the
Five-Step Decision-Making Process

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Five-Step
Decision-Making Process

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Relevance
Relevant Information has two characteristics:

It occurs in the future


It differs among the alternative courses of
action

Relevant Costs expected future costs


Relevant Revenues expected future

revenues

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Irrelevance
Historical costs are past costs that are

irrelevant to decision making

Also called Sunk Costs

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Types of Information
Quantitative factors are outcomes that can be

measured in numerical terms


Qualitative factors are outcomes that are
difficult to measure accurately in numerical
terms, such as satisfaction

Are just as important as quantitative factors


even though they are difficult to measure

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Terminology
Incremental Cost the additional total cost

incurred for an activity


Differential Cost the difference in total cost
between two alternatives
Incremental Revenue the additional total
revenue from an activity
Differential Revenue the difference in total
revenue between two alternatives

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Types of Decisions
One-Time-Only Special Orders
Insourcing vs. Outsourcing
Make or Buy
Product-Mix
Customer Profitability
Branch / Segment: Adding or Discontinuing
Equipment Replacement

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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One-Time-Only Special Orders


Accepting or rejecting special orders when

there is idle production capacity and the


special orders have no long-run implications
Decision Rule: does the special order
generate additional operating income?
Yes accept
No reject

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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One-Time-Only Special Orders


Compares relevant revenues and relevant

costs to determine profitability

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Potential Problems with


Relevant-Cost Analysis
Avoid incorrect general assumptions about

information, especially:
All variable costs are relevant and all fixed
costs are irrelevant
There are notable exceptions for both costs

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Potential Problems with


Relevant-Cost Analysis
Problems with using unit-cost data:

Including irrelevant costs in error


Using the same unit-cost with different output
levels

Fixed costs per unit change with different levels


of output

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Avoiding Potential Problems with


Relevant-Cost Analysis
Focus on Total Revenues and Total Costs,

not their per-unit equivalents


Continually evaluate data to ensure that they
meet the requirements of relevant information

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Insourcing vs. Outsourcing


Insourcing producing goods or services

within an organization
Outsourcing purchasing goods or services
from outside vendors
Also called the Make or Buy decision
Decision Rule: Select the option that will
provide the firm with the lowest cost, and
therefore the highest profit.

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Qualitative Factors
Nonquantitative factors may be extremely

important in an evaluation process, yet do not


show up directly in calculations:
Quality Requirements
Reputation of Outsourcer
Employee Morale
Logistical Considerations distance from
plant, etc.

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Opportunity Costs
Opportunity Cost is the contribution to operating

income that is forgone by not using a limited resource


in its next-best alternative use

How much profit did the firm lose out on by not


selecting this alternative?

Special type of Opportunity Cost: Holding Cost for

Inventory. Funds tied up in inventory are not


available for investment elsewhere

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Product-Mix Decisions
The decisions made by a company about

which products to sell and in what quantities


Decision Rule (with a constraint): choose the
product that produces the highest contribution
margin per unit of the constraining resource

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Adding or Dropping Customers


Decision Rule: Does adding or dropping a

customer add operating income to the firm?


Yes add or dont drop
No drop or dont add

Decision is based on profitability of the

customer, not how much revenue a customer


generates

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Adding or Discontinuing
Branches or Segments
Decision Rule: Does adding or discontinuing

a branch or segment add operating income to


the firm?
Yes add or dont discontinue
No discontinue or dont add

Decision is based on profitability of the

branch or segment, not how much revenue


the branch or segment generates

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Equipment-Replacement Decisions
Sometimes difficult due to amount of

information at hand that is irrelevant:


Cost, Accumulated Depreciation, and Book
Value of existing equipment
Any potential Gain or Loss on the transaction
a Financial Accounting phenomenon only

Decision Rule: Select the alternative that will

generate the highest operating income

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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Behavioral Implications
Despite the quantitative nature of some

aspects of decision making, not all managers


will choose the best alternative for the firm
Managers could engage in self-serving
behavior such as delaying needed equipment
maintenance in order to meet their personal
profitability quotas for bonus consideration

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright 2006 by Pearson Education. All rights reserved.

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