Decision Making and

Relevant Information
Chapter 11

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 Introduction

 This chapter explores the decision-making

process.
 It focuses on specific decisions such as
accepting or rejecting a one-time-only special
order, insourcing or outsourcing products or
services, and replacing or keeping equipment.

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 Learning Objectives

1 Use the five-step decision process to make

decisions
2 Differentiate relevant costs and revenues from
irrelevant costs and revenues in any decision
situation
3 Distinguish between quantitative factors and
qualitative factors in decisions

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 Learning Objectives

4 Identify two potential problems that should

be avoided in relevant-cost analysis
5 Describe the opportunity cost concept and
explain why it is used in decision making
6 Describe the key concept in choosing which
among multiple products to produce when
there are capacity constraints

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 Learning Objectives

7 Discuss the key factor managers must consider

when adding or dropping customers and segments
8 Explain why the book value of equipment is
irrelevant in equipment-replacement decisions
9 Explain how conflicts can arise between the
decision model used by a manager and the
performance model used to evaluate the manager

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 Learning Objective 1

Use the five-step decision

process to make decisions

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 Information and the
Decision Process
 A decision model is a formal method for
making a choice, often involving quantitative
and qualitative analysis.

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 Five-Step Decision Process

1 Gathering information
2 Making predictions
3 Choosing an alternative
4 Implementing the decision
5 Evaluating performance

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 Learning Objective 2

Differentiate relevant costs

and revenues from irrelevant
costs and revenues in any
decision situation

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 The Meaning of Relevance

 Relevant costs and relevant revenues are

expected future costs and revenues that differ
among alternative courses of action.

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 The Meaning of Relevance

 Historical costs are irrelevant to a decision but

are used as a basis for predicting future costs.
 Sunk costs are past costs which are
unavoidable.

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 The Meaning of Relevance

 Differential income (net relevant income) is

the difference in total operating income when
choosing between two alternatives.
 Differential costs (net relevant costs) are the
difference in total costs between two
alternatives.

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 Learning Objective 3

Distinguish between
quantitative factors and
qualitative factors in decisions

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 Quantitative and Qualitative
Relevant Information
 Quantitative factors are outcomes that are
measured in numerical terms:
– Financial
– Nonfinancial
 Qualitative factors are outcomes that cannot
be measured in numerical terms.

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 One-Time-Only Special Order

 Gabriela & Co. manufactures fancy bath towels

in Boone, North Carolina.
 The plant has a production capacity of 44,000
towels each month.
 Current monthly production is 30,000 towels.
 The assumption is made that costs can be
classified as either variable with respect to units
of output or fixed.

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One-Time-Only Special Order

Variable Fixed
Costs Costs
Per Unit Per Unit
Direct materials $6.50 $ -0-
Direct labor .50
1.50 Manufacturing costs 1.50
3.50 Total $8.50
$5.00

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 One-Time-Only Special Order

 Total fixed direct manufacturing labor

amounts to $45,000.
 Total fixed overhead is $105,000.
 Marketing costs per unit are $7 ($5 of which
is variable).
 What is the full cost per towel?

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 One-Time-Only Special Order

 Variable ($8.50 + $5.00): $13.50

 Fixed: 7.00
 Total $20.50
 A hotel in Puerto Rico has offered to buy
5,000 towels from Gabriela & Co. at $11.50
per towel for a total of $57,500.

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 One-Time-Only Special Order

 No marketing costs will be incurred for this

one-time-only special order.
 Should Gabriela & Co. accept this order?
 Yes!
 Why?

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 One-Time-Only Special Order

 The relevant costs of making the towels are

$42,500.
 $8.50 × 5,000 = $42,500 incremental costs
 $57,500 – $42,500 = $15,000 incremental
revenues
 $11.50 – $8.50 = $3.00 contribution margin
per towel

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 One-Time-Only Special Order

 Decision criteria:
 Accept the order if the revenue differential
is greater than the cost differential.

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 Learning Objective 4

Identify two potential problems

that should be avoided in
relevant-cost analysis

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 Potential Problems in
Relevant-Cost Analysis
 General assumptions:
– Do not assume that all variable costs are
relevant.
– Do not assume that all fixed costs are
irrelevant.

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 Potential Problems in
Relevant-Cost Analysis
 Unit-cost data can potentially mislead
decision makers:
– Irrelevant costs are included.
– The same unit costs are used at different
output levels.

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 Insourcing versus Outsourcing

 Outsourcing is the process of purchasing

goods and services from outside vendors
rather than producing goods or providing
services within the organization, which is
called insourcing.

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 Make-or-Buy Decisions

 Decisions about whether to outsource or

produce within the organization are often
called make-or-buy decisions.
 The most important factors in the make-or-buy
decision are quality, dependability of supplies,
and costs.

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 Make-or-Buy Decisions

 Gabriela & Co. also manufactures bath

accessories.
 Management is considering producing a
part it needs (#2) or using a part produced
by Alec Enterprises.

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 Make-or-Buy Decisions

 Gabriela & Co. has the following costs for

150,000 units of Part #2:
 Direct materials $ 28,000
Direct labor 18,500
Mixed overhead 29,000
Variable overhead 15,000
Fixed overhead 30,000
Total $120,500
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 Make-or-Buy Decisions

 Mixed overhead consists of material handling

and setup costs.
 Gabriela & Co. produces the 150,000 units in
100 batches of 1,500 units each.
 Total material handling and setup costs equal
fixed costs of $9,000 plus variable costs of
$200 per batch.

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 Make-or-Buy Decisions

 What is the cost per unit for Part #2?

 $120,500 ÷ 150,000 units = $0.8033/unit
 Alec Enterprises offers to sell the same part
for $0.55.
 Should Gabriela & Co. manufacture the part
or buy it from Alec Enterprises?

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 Make-or-Buy Decisions

 The answer depends on the difference in

expected future costs between the alternatives.
 Gabriela & Co. anticipates that next year the
150,000 units of Part #2 expected to be sold
will be manufactured in 150 batches of 1,000
units each.

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 Make-or-Buy Decisions

 Variable costs per batch are expected to

decrease to $100.
 Gabriela & Co. plans to continue to produce
150,000 next year at the same variable
manufacturing costs per unit as this year.
 Fixed costs are expected to remain the same
as this year.

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 Make-or-Buy Decisions

 What is the variable manufacturing cost

per unit?
 Direct material $28,000
Direct labor 18,500
Variable overhead 15,000
Total $61,500
 $61,500 ÷ 150,000 = $0.41 per unit

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 Make-or-Buy Decisions

 Expected relevant cost to make Part #2:

 Manufacturing $61,500 Material handling
and setups 15,000* Total relevant cost to
make $76,500 *150 × $100 = $15,000
 Cost to buy: (150,000 × $0.55) $82,500
 Gabriela & Co. will save $6,000 by making the
part.

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 Make-or-Buy Decisions

 Now assume that the $9,000 in fixed clerical

salaries to support material handling and setup
will not be incurred if Part #2 is purchased
from Alec Enterprises.
 Should Gabriela & Co. buy the part or make
the part?

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 Make-or-Buy Decisions

 Relevant cost to make:

 Variable $76,500
Fixed 9,000
Total $85,500
 Cost to buy: $82,500
 Gabriela would save $3,000 by buying
the part.

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 Learning Objective 5

Describe the opportunity cost

concept and explain why it is
used in decision making

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Opportunity Costs, Outsourcing,
and Constraints
 Assume that if Gabriela buys the part from
Alec Enterprises, it can use the facilities
previously used to manufacture Part #2 to
produce Part #3 for Krysta’s Company.
 The expected additional future operating
income is $18,000.
 What should Gabriela & Co. do?

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Opportunity Costs, Outsourcing,
and Constraints
 Gabriela & Co. has three options:
1 Make Part #2 and do not make Part #3 for
Krysta.
2 Buy Part #2 and do not make Part #3 for
Krysta.
3 Buy the part and use the facilities to produce
Part #3 for Krysta.

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Opportunity Costs, Outsourcing,
and Constraints
 Expected cost of obtaining 150,000 parts:
 Buy Part #2 Buy Part #2
and do not and make Make
make Part #3 Part #3 Part #2
$82,500 $64,500* $76,500
 *$82,500 – $18,000 = $64,500

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Opportunity Costs, Outsourcing,
and Constraints
 Opportunity cost is the contribution to income
that is foregone (rejected) by not using a
limited resource in its next-best alternative
use.

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Opportunity Costs, Outsourcing,
and Constraints
 Opportunity costs are not recorded in formal
accounting records since they do not generate
cash outlays.
 These costs also are not ordinarily
incorporated into formal reports.

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Opportunity Costs, Outsourcing,
and Constraints
 The opportunity cost of holding inventory is
the income forgone from tying up money in
inventory and not investing it elsewhere.

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Opportunity Costs, Outsourcing,
and Constraints
 Carrying costs of inventory can be a
significant opportunity cost and should be
incorporated into decisions regarding lot
purchase sizes for materials.

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Opportunity Costs, Outsourcing,
and Constraints
 Assume that annual estimated Part #2
requirements for next year is 150,000.
 Cost per purchase order is $40.
 Cost per unit when each purchase is of 1,500
units = $0.55.
 Cost per unit when each purchase is equal to
or greater than 150,000 = $0.54.

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Opportunity Costs, Outsourcing,
and Constraints
 Average investment in inventory is either:
 (1,500 x .55) ÷ 2 = $412.50 or
 (150,000 x $0.54) = $40,500
 Annual interest rate for investment in
government bonds is 6%.
 $412.50 × .06 = $24.75
 $40,500 × .06 = $2,430

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 Opportunity Costs, Outsourcing,
and Constraints
 Option A: Make 100 purchases of 1,500 units:
 Purchase order costs: (100 × $40) $ 4,000.00
 Purchase costs: (150,000 × $0.55) 82,500.00
 Annual interest income
that could be earned: 24.75
 Relevant costs $86,524.75

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Opportunity Costs, Outsourcing,
and Constraints
 Option B: Make 1 purchase of 150,000 units:
 Purchase order costs: (1 × $40) $ 40
 Purchase costs: (150,000 × $0.54) 81,000
 Annual interest income
that could be earned: 2,430
 Relevant costs: $83,470

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Opportunity Costs, Outsourcing,
and Constraints
 In this case purchasing all 150,000 units
at the beginning of the year is preferred.
 Why?
 The higher purchase and ordering costs
exceeds the lower opportunity cost of
holding smaller inventory.

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 Learning Objective 6

Describe the key concept in

choosing which among multiple
products to produce when there
are capacity constraints

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 Product-Mix Decisions Under
Capacity Constraints
 What product should be emphasized to
maximize operating income in the face of
capacity constraints?
 Gabriela & Co. produces Product #2 and
Product #3.
 The company has 3,000 machine hours
available to produce these products.

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 Product-Mix Decisions Under
Capacity Constraints
 Decision criteria:
Aim for the highest contribution margin per
unit of the constraining factor.
 When multiple constraints exist, optimization
techniques such as linear programming can be
used in making decisions.

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 Product-Mix Decisions Under
Capacity Constraints
 Per unit Product #2 Product #3
Sales price $2.11 $14.50
Variable expenses 0.41 13.90
Contribution margin $1.70 $ 0.60
 Contribution margin ratio 81% 4%

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 Product-Mix Decisions Under
Capacity Constraints
 One unit of Prod. #2 requires 7 machine hours.
 One unit of Prod. #3 requires 2 machine hours.
 What is the contribution of each product per
machine hour?
 Product #2: $1.70 ÷ 7 = $0.24
 Product #3: $0.60 ÷ 2 = $0.30

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 Product-Mix Decisions Under
Capacity Constraints
 Which product should be emphasized?
 The product with the highest contribution
margin per unit of the constraining resource.

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 Learning Objective 7

Discuss the key factor managers

must consider when adding or
dropping customers and
segments

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 Profitability, Activity-Based
Costing, and Relevant Costs
 Companies must often make decisions about
adding or discontinuing a product line, branch,
or business segment.
 Companies must also make decisions about
adding or dropping customers.

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 Profitability, Activity-Based
Costing, and Relevant Costs
 Blowing Rock Furniture supplies specialized
furniture to two local retailers – Stevens and
Cohen.
 Blowing Rock Furniture has a monthly
capacity of 3,000 machine hours.
 Fixed costs are allocated on the basis of
revenues.

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 Profitability, Activity-Based
Costing, and Relevant Costs
Stevens Cohen
Revenues $200,000
$100,000 Variable costs 70,000
60,000 Fixed costs 100,000
50,000 Total operating costs
$170,000 $110,000
Operating income $ 30,000 $
(10,000) Machine-hours required
2,000 1,000

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 Profitability, Activity-Based
Costing, and Relevant Costs

Total
Revenues $300,000
Variable costs 130,000
Fixed costs 150,000
Total operating costs $280,000
Operating income $ 20,000
Machine-hours required 3,000

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 Profitability, Activity-Based
Costing, and Relevant Costs
 Should Blowing Rock Furniture drop the
Cohen business, assuming that dropping
Cohen would decrease its total fixed costs
by 10%?
 New fixed costs would be:
$150,000 – $15,000 = $135,000

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 Profitability, Activity-Based
Costing, and Relevant Costs

Stevens Alone
Revenues $200,000
Variable costs 70,000
Fixed costs 135,000
Total operating costs $205,000
Operating income $ (5,000)
Machine-hours required 3,000

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 Profitability, Activity-Based
Costing, and Relevant Costs
 Cohen’s business is providing a contribution
margin of $40,000.
 $40,000 decrease in contribution margin –
$15,000 decrease in fixed costs = $25,000
decrease in operating income.

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 Profitability, Activity-Based
Costing, and Relevant Costs
 Assume that if Blowing Rock Furniture drops
Cohen’s business it can lease the excess
capacity to the Perez Corporation for $50,000.
 Fixed costs would not decrease.
 Should Blowing Rock Furniture lease to
Perez?

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 Profitability, Activity-Based
Costing, and Relevant Costs
 $50,000 would be Blowing Rock Furniture’s
opportunity cost of continuing serving Cohen.
 The $50,000 offsets the $40,000 contribution
of Cohen’s business.

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 Learning Objective 8

Explain why the book value

of equipment is irrelevant in
equipment-replacement
decisions

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 Equipment-Replacement
Decisions
 Assume that Gabriela & Co. is considering
replacing a cutting machine with a newer
model.
 The new machine is more efficient than the
old machine.
 Revenues will be unaffected.

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 Equipment-Replacement
Decisions
Existing Replacement
Machine Machine
Original cost $80,000 $105,000
Useful life 4 years 4 years
Accumulated depreciation $50,000
Book value $30,000
Disposal price $14,000
Annual costs $46,000
$ 10,000
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 Equipment-Replacement
Decisions
 Ignoring the time value of money and income
taxes, should Gabriela replace the existing
machine?
 Yes!
 The cost savings per year are $36,000.
 The cost savings over a 4-year period will be
$36,000 × 4 = $144,000.

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 Equipment-Replacement
Decisions
 Investment = $105,000 – $14,000 = $91,000
 $144,000 – $91,000 = $53,000 advantage of
the replacement machine.

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 Irrelevance of Past Costs

 The book value of existing equipment is

irrelevant since it is neither a future cost nor
does it differ among any alternatives (sunk
costs never differ).

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 Irrelevance of Past Costs

 The disposal price of old equipment and the

purchase cost of new equipment are relevant
costs and revenues because...
– they are future costs or revenues that differ
between alternatives to be decided upon.

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 Learning Objective 9

Explain how conflicts can arise

between the decision model
used by a manager and the
performance model used to
evaluate the manager

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 Decisions and Performance
Evaluation
 What is the journal entry to sell the existing
machine?
 Cash 14,000
Accumulated
Depreciation 50,000
Loss on disposal 16,000
Machine 80,000

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 Decisions and Performance
Evaluation
 In the real world would the manager replace
the machine?
 An important factor in replacement decisions
is the manager’s perceptions of whether the
decision model is consistent with how the
manager’s performance is judged.

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 Decisions and Performance
Evaluation
 Managers often behave consistent with their
short-run interests and favor the alternative
that yields best performance measures in the
short run.
 When conflicting decisions are generated,
managers tend to favor the performance
evaluation model.

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 Decisions and Performance
Evaluation
 Top management faces a challenge – that is,
making sure that the performance-evaluation
model of subordinate managers is consistent
with the decision model.

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End of Chapter 11

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