Decision Making and

Relevant Information
Chapter 3
 Learning Objective 1

Use the five-step decision

process to make decisions.
 Information and the
Decision Process

A decision model is a formal method

for making a choice, often involving
quantitative and qualitative analysis.
 Five-Step Decision Process
Historical Costs
Step 1. Gather Information
Other Information

Step 2. Make Predictions Specific Predictions

Feedback

Step 3. Choose an Alternative

Step 4. Implement the Decision

Step 5. Evaluate Performance

Learning Objective 2

Differentiate relevant
from irrelevant
costs and revenues in
decision situations.
 The Meaning of Relevance

Relevant costs and relevant revenues are

expected future costs and revenues that
differ among alternative courses of action.
Historical costs Sunk costs
Differential income Differential costs
 Learning Objective 3

Distinguish between quantitative

and qualitative factors in decisions.
Quantitative and Qualitative
Relevant Information

Quantitative factors

Financial Nonfinancial

Qualitative factors
 One-Time-Only
Special Order Example

The Bismark Co. manufacturing plant has a

production capacity of 44,000 towels each month.
Current monthly production is 30,000 towels.
Costs can be classified as either variable or fixed
with respect to units of output.
 One-Time-Only
Special Order Example

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
 One-Time-Only
Special Order Example

Total fixed direct manufacturing labor is $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?
 One-Time-Only
Special Order Example

Variable ($8.50 + $5.00): $13.50

Fixed: 7.00
Total $20.50
A hotel in San Juan has offered to buy
5,000 towels from Bismark Co. at
$11.50/towel for a total of $57,500.
No marketing costs will be incurred.
 One-Time-Only
Special Order Example

What are the relevant costs of making the towels ?

$8.50 × 5,000 = $42,500 incremental costs
What are the incremental revenues ?
$57,500 – $42,500 = $15,000
 Learning Objective 4

Beware of two potential

problems in
relevant-cost analysis.
 Two Potential Problems in
Relevant-Cost Analysis
1 2
Incorrect general Misleading
assumptions: unit-cost data:
All variable costs Include
are relevant. irrelevant costs.
All fixed costs Use same unit
are irrelevant. costs at different
output levels.
 Outsourcing versus Insourcing

Outsourcing is Insourcing is
purchasing goods producing goods
and services from or providing services
outside vendors. within the organization.
 Make-or-Buy Decisions Example

Bismark Co. also manufactures bath accessories.

Management is considering producing a part it
needs (#2) or buying a part produced
by Towson Co. for $0.55.
Make-or-Buy Decisions Example
Bismark 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
Make-or-Buy Decisions Example

Mixed overhead consists of material

handling and setup costs.
Bismark 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.
Make-or-Buy Decisions Example

What is the cost per unit for Part #2?

$120,500 ÷ 150,000 units = $0.8033/unit
Should Bismark Co. manufacture the part
or buy it from Towson Co.?
Make-or-Buy Decisions Example

Bismark 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.
Make-or-Buy Decisions Example

Variable costs per batch are expected to

decrease to $100.
Bismark 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.
 Make-or-Buy Decisions Example

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
 Make-or-Buy Decisions Example

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
Bismark Co. will save $6,000 by making the part.
 Make-or-Buy Decisions Example

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 Towson Co..
Should Bismark Co. buy the part or make the part?
Make-or-Buy Decisions Example

Relevant cost to make:

Variable $76,500
Fixed 9,000
Total $85,500
Cost to buy: $82,500
Bismark would save $3,000 by buying the part.
 Learning Objective 5

Explain the opportunity-cost

concept and why it is
used in decision making.
 Opportunity Costs,
Outsourcing, and Constraints

Assume that if Bismark buys the part from

Towson, it can use the facilities previously
used to manufacture Part #2 to produce
Part #3 for Krysta Company.
The expected additional future operating
income is $18,000.
What should Bismark Co. do?
 Opportunity Costs,
Outsourcing, and Constraints

Bismark Co. has three options regarding Krysta:

1. Make Part #2 and do not make Part #3.
2. Buy Part #2 and do not make Part #3.
3. Buy the part and use the facilities to produce
Part #3.
 Opportunity Costs,
Outsourcing, and Constraints

Expected cost of obtaining 150,000 parts:

Buy Part #2 and do not make Part #3: $82,500
Buy Part #2 and make Part #3:
$82,500 – $18,000 = $64,500
Make Part #2: $76,500
 Opportunity Costs,
Outsourcing, and Constraints

Opportunity cost is the contribution to income

that is forgone (rejected) by not using a
limited resource in its next-best alternative use.
 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
1,500 units = $0.55.
Cost per unit when each purchase is equal
to or greater than 150,000 = $0.54.
 Opportunity Costs,
Outsourcing, and Constraints
Average investment in inventory is either:
(1,500 × .55) ÷ 2 = $412.50 or
(150,000 × $0.54) = $40,500
Annual interest rate for investment in
government bonds is 6%.
$412.50 × .06 = $24.75
$40,500 × .06 = $2,430
 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: $ 24.75
Relevant costs: $86,524.75
 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: $ 2,430
Relevant costs: $83,470
 Learning Objective 6

Know how to choose which

products to produce when there
are capacity constraints.
 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%
Bismark Co. has 3,000 machine-hours available.
 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
 Learning Objective 7

Discuss what managers

must consider when
adding or discontinuing
customers and segments.
 Profitability, Activity-Based
Costing, and Relevant Costs

Mountain View Furniture supplies furniture

to two local retailers – Stevens and Cohen.
The company has a monthly capacity
of 3,000 machine-hours.
Fixed costs are allocated on the basis of revenues.
 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
 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
 Profitability, Activity-Based
Costing, and Relevant Costs

Should Mountain View 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
 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
 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.
 Profitability, Activity-Based
Costing, and Relevant Costs

Assume that if Mountain View Furniture drops

Cohen’s business it can lease the excess capacity
to the Perez Corporation for $70,000.
Fixed costs would not decrease.
Should Mountain View Furniture lease to Perez?
 Learning Objective 8

Explain why the book value

of equipment is irrelevant in
equipment-replacement decisions.
 Equipment-Replacement
Decisions Example
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
 Equipment-Replacement
Decisions Example
Ignoring the time value of money and
income taxes, should the company
replace the existing machine?
The cost savings over a 4-year period will be
$36,000 × 4 = $144,000.
Investment = $105,000 – $14,000 = $91,000
$144,000 – $91,000 = $53,000
advantage of the replacement machine.
 Learning Objective 9

Explain how conflicts can arise

between the decision model
used by a manager and the
performance evaluation model
used to evaluate the manager.
 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
 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.
 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.
End of Chapter 11