Chapter 10 Relevant Information for Decision Making Cost

Chapter 10: Relevant Information for Decision Making Cost Accounting: Foundations and Evolutions, 8 e Kinney ● Raiborn

Learning Objectives n n n n What factors determine the relevance of information to decision making? What are sunk costs, and why are they not relevant in making decisions? What information is relevant in an outsourcing decision? How can management achieve the highest return from use of a scarce resource? What variables do managers use to manipulate sales mix? How are special prices set, and when are they used? How do managers determine whether a product line should be retained or discontinued? (Appendix) How is linear programming used to optimally manage multiple resource constraints?

Relevant Costing n n Relevant Costing focuses managerial attention on a decision’s relevant facts Relevance q q q n n Associated with the decision under consideration Important to the decision maker Connected to or bearing on some future endeavor Most variable costs are relevant Most fixed costs are not relevant

Incremental Revenue, Cost, & Profit/Loss n n n Incremental Revenue—the amount of revenue that differs across decision choices Incremental Cost or Differential Cost—the amount of cost that varies across decision choices Incremental Profit or Loss—the difference between incremental revenue and incremental cost

Opportunity & Sunk Costs n n Opportunity Costs—benefits foregone because one course of action is chosen over another Sunk Costs—costs incurred in the past to acquire an asset or a resource q q Not relevant because they cannot be changed regardless of future actions Not recoverable SUNK COSTS ARE IRRELEVANT.

Relevant Costing & Business Decisions n n Outsourcing a product or part Allocating scarce resources Accepting special orders Determining the sales/production mix

Outsourcing & Make-or-Buy Decions n n n Outsourcing—having work performed for one company by an off-site non-affiliated supplier Offshoring—sending a job formerly performed in the home country to a foreign country Make-or-Buy decisions compare internal production and opportunity costs with purchase cost q Relevant information: n n n Strategic Economic Technological Management and human resources Most outsourcing relates to operating costs not to strategic core competencies

Make-or-Buy—Quantitative Factors § Incremental production costs per unit § Cost to purchase outside § Number of available suppliers § Production capacity available § Opportunity costs of production facilities q q q Space available for storage Inventory carrying costs Increase in throughput from buying components

Make-or-Buy—Qualitative Factors n n n n Reliability of supply sources Ability to control quality of items purchased outside Nature/importance of the work to be subcontracted Impact on customers and markets Future bargaining position with supplier(s) Perceptions about future price changes Perceptions about current product prices

Outsourcing Risk Pyramid Outsource under Tight Control Outsource under Service Levels Never Outsource Strategic Direction, Unique Core Competencies Tax, Audit, Legal Information Technology Help Desk, Call Centers Data Centers, Logistics Low-Risk Outsourcing Facility, Network, Supply-Chain Management, Temporary Staffing, Payroll, Security Services, Food Services

Services Often Outsourced n n n n Accounting and legal services School bus programs Medical—blood testing Process design activities Utilities Engineering services Employee health services

Scare Resources n Essential to production activity but available only in limited quantity q q Machine hours Skilled labor hours Raw materials Production capacity n n n Choose product or service with highest contribution margin per unit of scarce resource When there are several limiting factors, use linear programming to choose product or service Before eliminating products or services, consider qualitative factors q q Company reputation Impact on customer base Market saturation Company stagnation

Production Choices n Production and sale of some less profitable products may be necessary to maintain either customer satisfaction or sales of other products Low CM on razors may be required to obtain high CM on razor blades

Sales Mix Decisions Sales Mix—relative quantities of the products that make up the total sales of a company n Factors affecting sales mix: n Product selling prices q Sales force compensation q Advertising expenditures q

Impact of Change in Sales Price n Quantitative Factors q q q New contribution margin per unit of each product Changes in product demand production volume Best use of scarce resources n Qualitative Factors q q Customer goodwill Customer loyalty Response of competitors Production of new products

Pricing New Products n n Consider the product’s entire life cycle (long run) To set prices at various stages in the product’s life cycle, make assumptions about: q q q q Consumer behavior Competitor behavior Pace of technology changes Government posture Environmental concerns Size of potential market Demographic changes

Impact of Change in Compensation n Commission based on fixed percentage of gross sales dollar q n Commission based on product contribution margin q n Sell highest priced product Sell most profitable product When considering compensation structure q Ignore fixed costs unless the fixed costs are incremental relative to the new policy or to changes in sales volume

Impact of Change in Advertising n Increase in advertising costs may cause q q n Change in sales mix Change in sales volume Advertising budget changes q Relevant costs n Increased sales revenue Increased variable costs n Increased fixed costs n q Irrelevant costs include n n Original fixed costs Contribution margin generated by the current sales levels Incremental Revenues Less: Incremental Variable Costs equals Incremental Contribution Margin Less: Incremental Fixed Costs equals Incremental Benefit (or Loss)

Special Order Decisions Special order decisions involve management computing a reasonable sales price for products or services not part of normal operations. § Sales price should cover: q q q Variable production and selling costs Incremental fixed costs Profit n Special prices can be considered for: q q Unusual quantity, delivery, packaging, or customization of product One-time job such as an overseas order that will not affect the domestic market

Private-Label Orders, Low-Ball Bids & Ad Hoc Discounts n Private-label order q q q Buyer’s name (not producer’s) attached to the product Accept during slack periods to use available capacity Fixed costs usually not allocated Variable selling costs often reduced/eliminated Sales price set to generate a positive contribution margin n Low-ball bid q q q n To introduce product or service to particular market Sales price at or below cost Cannot be continued over the long run Ad Hoc Discounts q Price concessions related to real (or imagined) competitive pressures rather than to the location of the merchandising chain or volume purchased

Special Order Decisions – Qualitative Factors n n n Impact on future prices and sales Sufficient contribution margin to justify the additional burden on workers and management Impact on scarce resources and throughput Keep workforce employed during slow times Consider Robinson-Patman Act q q Prohibits companies from pricing the same product at different levels when those amounts do not reflect related cost differences Requires that cost differences result from actual variations in the cost to manufacture, sell, or distribute because of different methods of production or quantities sold

Product Line and Segment Decisions n Multiproduct Environments q q n n Costs by product lines Costs of divisions Separate costs by q Product Line n Distinguish between relevant and irrelevant information n Commingling relevant and irrelevant information may suggest a product line/ segment is operating at a loss when it is actually operating at a profit n q n Revenue Variable costs Avoidable direct fixed costs Unavoidable direct fixed costs Common Costs Unavoidable Direct Fixed Costs and Common Costs q q Will continue even if a product line or segment is eliminated Are irrelevant costs when deciding to eliminate a product line or segment

Segment Margin Income Statement Use segment margin to decide to continue or eliminate a segment Sales <Variable Expenses> Contribution Margin <Avoidable/Attributable Fixed Expenses> Segment Margin <Unavoidable Fixed Expenses> Product Line Result <Allocated Common Expenses> Net Income (Loss)

Product Line Decisions – Beware n n Proceeds from sale of equipment are relevant Costs that appear to be avoidable may not be Depreciation on equipment is irrelevant Eliminating a product may affect customers q Customers seek products elsewhere due to shrinking market assortment

Appendix—Linear Programming n Linear Programming q Used to find the optimal allocation of scarce resources in a situation involving one objective and multiple limiting factors n n n q n n Resource constraints Demand or marketing constraints Technical product constraints Nonnegativity constraints Whole number constraints Helps managers allocate scarce resources among competing uses One objective q Maximize contribution margin q Minimize product cost Optimal solution—provides best answer to allocation problem

Questions n n n What are some relevant financial considerations when making an outsourcing decision? How are prices set for special orders? What types of decisions require segment margin income statements?

Potential Ethical Issues n n n Ignoring qualitative factors in decisions Going offshore to exploit lax environmental and labor standards Making decisions based on financial earnings impact Using bait-and-switch advertising techniques Setting prices that violate the Robinson-Patman Act or other pricing regulations Substituting materials that pose health or environmental risks in a scarce resource situation