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Chapter 11

(c) 2012 Pearson Prentice Hall. All rights reserved.

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A. Objectives / Expected Learning Outcomes


(Course Outline)
1.
2.

Chapter 11: Relevant Information Decision Making


After studying this Chapter, you should be able to:
Master the Relevant Costs Concepts and apply the
knowledge to manufacturing, merchandising and
service companies.
Use the information from management accounting
systems to improve the competitiveness of the
companies in operational excellence, product
leadership (product mix, next slide), and customer
service.
Develop skills and ability to solve problems that
they will need to succeed in a business
environment.
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B. Content
1.
2.

Relevant Costs
Types of decisions that need to be made (slide 15):
One-time-only Special Orders
Insourcing vs Outsourcing (Make or Buy)
Product-Mix with Capacity Constraints
Customer Profitability and Relevant Costs
Branch / Segment: Adding or Discontinuing
Equipment Replacement

C. Learning Resources
1.
2.

Textbook, Chapter 11, page 446-493


PowerPoint (PPT)
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D. Learning Activities
1.
2.
3.

Lecture (sharing of key concepts and ideas)


Discussions (sharing by students)
Available Technology (visual presenter + PPT + Clicker)

E. Assessment
1.
2.

In Class Exercise (Clicker): MC Format


HW Assignment (in MC Format, Open-ended Question
Format, and Essay Format)

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1.
2.
3.

4.

Use the five-step decision-making process


Distinguish relevant from irrelevant
information in decision situations
Explain why managers should consider the
costs when making insourcing-versusoutsourcing decisions
Know how to choose which product to
produce when there are capacity constraints

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5.

6.

7.

Discuss the factors managers must consider


when adding or dropping customers or
business units
Explain why book value of equipment is
irrelevant to managers making equipmentreplacement decisions
Explain how conflicts can arise between the
decision model a manager uses and the
performance-evaluation model top
management uses to evaluate managers

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Managers usually follow a decision model for


choosing among different courses of action.
A decision model is a formal method of making a
choice that often involves both quantitative and
qualitative analyses.
Management accountants analyze and present
relevant data to guide managers decisions.
Managers use the five-step decision-making
process presented in Chapter 1 (slide 15) to make
decisions.

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Relevant information has two characteristics:


It

occurs in the future


It differs among the alternative courses of
action.

Relevant costs (slide 11) are expected future


costs.
Relevant revenues (slide 11) are expected
future Revenues.
Past costs (historical costs) are never
relevant and are also called sunk costs (slide
13).
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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.
Qualitative

factors are just as important as


quantitative factors even though they are
difficult to measure.

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Past (historical) costs may be helpful as a basis for making


predictions. However, past costs themselves are always
irrelevant when making decisions.
Different alternatives can be compared by examining
differences in expected total future revenues and
expected total future costs.
Not all expected future revenues and expected future
costs are relevant. Expected future revenues and
expected future costs that do not differ among
alternatives are irrelevant and, hence can be eliminated
from the analysis (see next slide). The key question is
always, What difference will an action make?
Quantitative and qualitative factors should be considered.
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Costs that have already occurred and cannot be


changed are classified as sunk costs.
Sunk costs are excluded (slide 9) because they
cannot be changed by future actions.

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Incremental cost (slide 17) 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.
Note that incremental cost and differential
cost are sometimes used interchangeably in
practice.
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1.
2.
3.
4.
5.
6.

One-time-only special orders (slide 16-19)


Insourcing vs. Outsourcing (Make-or-Buy)
(slide 20-24)
Product-mix with capacity constraints (slide
25-28)
Customer Profitability and Relevant Costs
(slide 29-33)
Branch / Segment: adding or discontinuing
(slide 34)
Equipment Replacement (slide 35-41)
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Accepting or rejecting special orders when


there is
production capacity and the
special orders have ________________
implications.
Decision rule: Does the special order
generate additional operating income?
Yesaccept
Noreject

Compares relevant revenues and relevant


costs (slide 9) to determine profitability.

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Background Information: A customer offers to


purchase 5,000 units at $11 per unit, which is $9
less than the usual selling price.
Question: Should the special order be accepted?
Things to note:
1. Decision Rule: Does the special order
generate additional operating income?
If yes, then accept the special order.
2. The only incremental costs (slide 14) are
the ___________ manufacturing costs.
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Discussion / Result:
Decision Rule: Does the special order generate
additional operating income? If yes, then
accept the special order.

1. Column D, Operating Income: $30,000.


2. Column F, Operating Income: $47,500 if the
special order is accepted.
3. Column H. Difference: $17,500.
4. Generate ___________ operating income.
5. ___________ the special order.
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Insourcing means youll produce the good (or


provide the service) within the organization.
Outsourcing is purchasing goods and services
from outside vendors.
Decisions about whether to insource or
outsource are called Make-or-Buy decisions.

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Decision rule: Select the option that will


provide the firm with the lowest cost, and
therefore the highest profit.
Same as special order: choose the
alternative that maximizes operating
income.

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Background Information: A company needs 250,000 units of


a good produced in 2,000 batches of 125 units each.
The company could purchase the good for $64 per unit.
Question: Should the company make or buy the good?
Things to note:
1. Consider the manufacturing costs (Direct Materials,
_______________________________,
Manufacturing Overhead Cost). (Total Amount: 15
million dollar) for making the product.
2. Consider 16 million dollar (250,000 units x $64
selling price) for purchasing / buying.

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Total Relevant
Costs
Relevant Items
Make
Buy
Outside purchase of parts ($64 * 250,000
$16,000,0
units)
00
$9,000,00
Direct materials
0
$2,500,00
Direct manufacturing labor
0
$1,500,00
Variable manufacturing overhead
0
Mixed (variable and fixed) materials $2,000,00
handling and setup overhead
0
$15,000,0 $16,000,0
Total relevant costs (a)
00
00
Difference in favor of making DVD players

$1,000,000

Relevant
Cost Per
Unit
Make Buy
$64
$36
$10
$6
$8
$60

$64

$4

(a) The $3,000,000 of plant-lease, plant-insurance, and plant-administration


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costs could be included under both alternatives. Conceptually, they
do not

Discussion / Result:
Decision rule: Select the option that will provide the firm
with lowest cost, and therefore the highest Profit.
1. We see an analysis of the relevant costs for this
decision ($15 million vs $16 million).
2. Since it costs _____ to make the item, therefore,
production should remain in-house.
3. As with special order decision, strategic and
qualitative factors cannot be ignored.
4. Also, regardless of this financial outcome, perhaps the
company prefers to retain in-house control over
quality issue.
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Product-mix decisions are decisions managers


make about which product 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 (see example
on next slide) (not the highest
contribution margin per unit of the
product).
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Background Information:

Two products (Product A and Product B).


Machine hour is limited; therefore, machine hour is the
_____________________ resources.

Question: Which product (A or B) may maximize the


companys profit?
Things to note:
1. Consider the contribution margin per unit of
the constraining resource
(i.e. _____________________)

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Product A

Product B

Selling Price

$10.00

$30.00

Variable Cost per unit

$ 6.00

$15.00

Contribution Margin / Unit (Ch. 3)

$ 4.00

$15.00

Contribution Margin Percentage (Ch. 10)

40%

50%

Machine Hours required per unit

0.5

3.0

$ 8.00

$ 5.00

Contribution Margin / Machine Hour

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Discussion / Result:
Decision rule: Choose the product that produces the
highest contribution margin per unit of the
constraining resource.
1. Product A: CM per unit = $4
2.
3.
4.
5.

Product B: CM per unit = $15


Constraining Resource is the Machine Hour.
Machine Hour required per unit is 0.5 and 3 for
Product A and B respectively.
Product A: CM per machine hour = $4/0.5 = $8
Product B: CM per machine hour = $15/3 = $5
Produce Product ___ to maximize the profit.
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When the cost object (Chapter 2) is a


customer, managers must decide about
adding or dropping the customer.
Decision rule: Does adding or dropping a
customer add operating income to the firm?

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Background Information:
The

Company faces the question of whether or


not it should drop Customer C who appears to
have a negative impact on operating income
(see next slide).
They are also considering adding a Customer,
D, who have the same revenues and costs as
Customer C plus the requirement of additional
equipment with $9,000 depreciation (see slide
32). Also, Rent, General Administration Cost,
and Corporate Office Costs will not change (see
slide 32).
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Revenues
Cost of goods sold
Furniture-handling labor
Furniture-handling equipment
cost written-off as depreciation
Rent
Marketing support
Sales-order and delivery
processing
General administration
Allocated corporate-office costs
Total costs

Customer
A
B
C
Total
$300,0 $400,00 $1,200,0
$500,000
00
0
00
220,00
370,000
0
330,000 920,000
41,000 18,000 33,000 92,000
12,000
14,000
11,000
13,000
20,000
10,000

4,000
8,000
9,000

7,000
12,000
6,000
284,00
491,000
0
$16,00

9,000
14,000
10,000
12,000
16,000
8,000

25,000
36,000
30,000

32,000
48,000
24,000
1,207,00
432,000
0
($32,00
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(Incremental Loss
in Revenues) and
Incremental
Savings in Costs
from Dropping C
Account (1)
($400,000)
330,000
33,000

Incremental
Revenues and
(Incremental
Costs) from
Adding D
Account (2)
$400,000
(330,000)
(33,000)

Furniture-handling equipment cost


written-off as depreciation
Rent
Marketing support
Sales-order and delivery processing
General administration
Corporate-office costs
Total costs

0
0
10,000
12,000
0
0
385,000

(9,000)
0
(10,000)
(12,000)
0
0
(394,000)

Effect on operating income (loss)

($15,000)

$6,000

Revenues
Cost of goods sold
Furniture-handling labor

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Discussion / Result:
1. Looking at this relevant revenues / relevant cost
analysis, we see that dropping the C account
would
actually ____________ operating income by
$15,000.
2. Adding the D account will _______________
operating income $6,000.
3. Note that for D, Rental Cost, General Administration
Cost, and Corporate Office Cost are not relevant
because they dont change whether or not D is
added (background information, slide 30). On the
other hand, the additional ________________ cost
is relevant for D since the $9,000 will only occur if
that customer is added.

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Decision rule: Does adding or discontinuing a


branch or segment add operating income to the
firm?

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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.

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Original cost
Useful life
Current age
Remaining useful life
Accumulated depreciation
Book value
Current disposal value (in cash)
Terminal disposal value (in cash, 2 years
from now)
Annual operating costs (maintenance,
energy, repairs, coolants, and so on)

Old machine New machine


$1,000,000
$600,000
5 years
2 years
3 years
0 year
2 years
2 years
Not acquired
$600,000
yet
Not acquired
$400,000
yet
Not acquired
$40,000
yet
$0

$0

$800,000

$460,000

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Background Information:
The Company uses straight line
depreciation.
The Company will make a decision about
whether or not to replace equipment.

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Two Years Together


Differenc
e
Keep
Replace
(3)=(1)(1)
(2)
(2)
$2,200,000 $2,200,000
0

Revenues
Operating costs
Cash operating costs ($800,000 / year *
2 years; $460,000 / year * 2 years)
1,600,000
Book value of old machine
Periodic write-off as depreciation or
400,000
Lump-sum write-off (a)
Current disposal value of old machine
(a)
New machine cost, written off
periodically as depreciation
Total operating costs

0
2,000,000

Operating income

$200,000

920,000

680,000

400,000
(400,000
)

400,000

(40,000)

40,000
(600,000
600,000
)
1,880,000 120,000
($120,00
$320,000
0)
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Journal Entry:

Discussion / Result:
Decision rule: Select the alternative that will
generate the highest operating income.
1. Replacing the machine will _______________
operating income by $120,000.
2. Now, lets take a look at the relevant cost only
(next slide) and see if it gives the same decision.
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Here, we see the analysis showing relevant


costs (previous slide) only.
Discussion / Result:
Decision rule: Select the alternative that will
generate the highest operating income.
1. Replacing the machine will _______________
operating income by $120,000.
2. It gives us the __________ decision even though
just looking at the relevant costs.
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TERMS TO LEARN

PAGE NUMBER REFERENCE

Book value

Page 448

Business function costs

Page 429

Constraint

Page 455

Decision model

Page 425

Differential cost

Page 433

Differential revenue

Page 434

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TERMS TO LEARN

PAGE NUMBER REFERENCE

Insourcing

Page 432

Make-or-buy decisions

Page 432

One-time-only special order

Page 428

Outsourcing

Page 432

Product-mix decisions

Page 440

Qualitative factors

Page 428

Quantitative factors

Page 427

Relevant costs

Page 426

Relevant revenues

Page 426

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