Prepared by Debby Bloom-Hill CMA, CFM. Slide 7-2 CHAPTER 7 The Use of Cost Information in Management Decision Making

Prepared by Debby Bloom-Hill CMA, CFM

Slide 7-2

CHAPTER 7CHAPTER 7

The Use of Cost Information in Management

Decision Making

The Use of Cost Information in Management

Decision Making

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Incremental AnalysisIncremental Analysis

Incremental analysis All decisions involve a choice among

alternative courses of action The solution to business problems

involves incremental analysis Incremental analysis is the analysis of the

incremental revenue and incremental costs incurred when one alternative is chosen over another

Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

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Incremental Revenue Additional revenue received by selecting

one alternative over another Incremental Cost

Additional cost incurred by selecting one alternative over another

Incremental Profit Difference between incremental revenue

and incremental cost


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An alternative that yields an incremental profit should be selected

Incremental costs are referred to as relevant costs

Also called differential costs because they are the costs that differ between decision alternatives


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Incremental Analysis ExampleIncremental Analysis Example

Jensen’s Rapid Copy is considering extending its hours Alternative 1 is the status quo Alternative 2 involved the company

extending their hours from 8 pm to midnight The next slide shows the incremental

costs and revenues associated with choosing one alternative over another


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Incremental Analysis ExampleIncremental Analysis Example


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Incremental Analysis can be extended to more than two alternatives Calculate profit for each alternative The alternative with the highest profit is

the best alternative Difference between the profit for this

alternative and the profit of any other alternative is the incremental profit


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“What Does This Product Cost?”“What Does This Product Cost?”

Answer: Why do you want to know? No single cost number is relevant for all

decisions Must find incremental information that is

applicable to the decision Some costs will change due to the

decision, some will not Only costs that change are relevant


Which of the following is likely to be an incremental cost associated with increasing planned production run of 1,000 units to 1,010 units?

a. Set-up costsb. Depreciation of equipmentc. Inspection costsd. Material costs

Answer: dMaterial costs are variable costs and usually incremental

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Analysis of Decisions Faced by Managers

Analysis of Decisions Faced by Managers

Three decisions that managers frequently face:

1. The decision to engage in additional processing of a product

2. The decision to make or buy a product

3. The decision to drop a product line


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Additional Processing DecisionAdditional Processing Decision

Manufacturers must occasionally decide whether to: Sell a product in a partially completed

stage, or Incur additional processing costs required

to complete the product Costs incurred to date of decision on

partially complete product are not relevant, i.e sunk costs.


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Additional Processing Decision – Bridge Computer Example


Summary of cost information


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Incremental analysis summary Incremental revenues are $500 Incremental costs are $400 Would you spend $400 to generate an

additional $500?

Answer: Yes, incremental profit is $100

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Incremental analysis summary

Sell Partially

CompleteSell Fully Complete Incremental

Revenue $500 $1,000 $500 aPrior Production Costs (800) (800) 0Additional Processing Costs 0 (400) (400) bGain (loss) per unit ($300) ($200) $100 c

a. Incremental revenue associated with alternative 2b. Incremental cost associated with alternative 2c. Incremental profit associated with alternative 2


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Additional Processing DecisionAdditional Processing Decision

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Make or Buy DecisionsMake or Buy Decisions

Most manufactured goods are made up of numerous components In some cases, a company may purchase

one or more of these components from another company or manufacture them themselves

The analysis of this decision concentrates solely on incremental costs


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Make-or-Buy Decisions – General Refrigeration Example


Additional information: If purchased, cost

savings include $390,000 in supervisory salaries and all variable costs.

Market value of production machinery is zero

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A key issue is to determine which of the above costs are incremental None of the $15 million of variable

manufacturing costs will be incurred if the part is purchased

The fixed costs associated with depreciation will not be saved Note that not all fixed costs are irrelevant

sunk costs




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Some fixed costs are avoidable costs Avoidable costs can be avoided if a

particular action is undertaken If the parts are purchased from an outside

vendor, the salaries of 5 supervisors will be saved The savings total $390,000 of avoidable

fixed costs It will cost the company an additional

$110,000 to purchase the part




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Incremental cost analysis – 3 column format


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Incremental cost analysis - single column format


Which of the following is not likely to be an incremental cost for a make-or-buy decision?

a. Materials costb. Direct labor costc. Variable manufacturing costd. Depreciation of building

Answer: dDepreciation of building is not likely to change no matter which alternative is chosen in a make-or-buy decision

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An opportunity cost is the value of benefits foregone by selecting one decision alternative over another For example, if you spend $1,000 instead

of investing in a certificate of deposit, the interest that could have been earned is an opportunity cost

Since opportunity costs differ depending on the option selected, they are incremental costs

Opportunity CostsOpportunity Costs


Which of the following is true?

a. Opportunity costs are never incremental costs

b. Opportunity costs are always incremental costs

Answer: bOpportunity costs are always incremental costs because they differ depending upon the outcome selected

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Suppose the Tennessee plant is currently spending $500,000 per year to rent space for manufacturing shelving used in the refrigeration units

If production of compressors is discontinued, the company will not need to rent the space In the incremental analysis on the next slide,

the rent savings is shown along with the other cost savings

Opportunity Costs – General Refrigeration Example

Opportunity Costs – General Refrigeration Example


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Incremental analysis with opportunity costs


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Dropping a Product LineDropping a Product Line

Analysis involves calculating the change in income that will result from dropping the product line If income increases, the product line

should be dropped If income decreases, the product line

should not be dropped This amounts to comparing the incremental

revenues and costs that result from dropping the product line


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Dropping a Product Line – Mercer Hardware

Dropping a Product Line – Mercer Hardware

Mercer Hardware sells 3 product lines, tools, hardware and garden Direct fixed costs are directly traceable to

each product line Allocated fixed costs are not directly

traceable to a product line Allocated fixed costs are generally not

avoidable, thus no common fixed costs will be saved if the product line is dropped


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Dropping a Product Line – Mercer Hardware Example


Profit calculation with three product lines


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Profit calculation with two product lines

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Beware of the Cost Allocation Death Spiral

Beware of the Cost Allocation Death Spiral

When dropping a product line Common fixed costs are not incremental Common fixed cost allocation is spread

among remaining product lines Management must understand and

remember this impact when making decisions


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Summary of Incremental, Avoidable, Sunk and Opportunity Costs


Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental Avoidable costs

Costs that can be avoided by taking a particular course of action

Always incremental costs, and therefore relevant to a decision


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Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental Sunk costs

Already occurred and not reversible Are not incremental because they do not

differ among alternatives Are not relevant in decision making


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Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental Many students assume that fixed costs

are equivalent to sunk costs This is not always the case Fixed costs can be sunk, not sunk and

irrelevant, or possibly relevant


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Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental Opportunity costs

Represent the benefit foregone by selecting a particular alternative

They are always incremental and relevant to a decision


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Which of the following costs should not be taken into consideration when making a decision?

a. Opportunity costsb. Sunk costsc. Relevant costsd. Differential costs

Answer: bSunk costs


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Classify each of the following as sunk and irrelevant, not sunk but still irrelevant, or not sunk and relevant

Depreciation on equipment already purchasedSunk and irrelevant (not incremental)

President’s salary, which will not change for both action A and action B

Not sunk and irrelevant (not incremental)Salary of supervisory who will be retained for action A and fired for action B

Not sunk and relevant (incremental)


Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.

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Decisions Involving Joint CostsDecisions Involving Joint Costs

Joint Products When two or more products always result

from common inputs Joint Costs

Costs of the common inputs Split-Off Point

Stage of production in which individual products are identified

Product may undergo further processing and may incur additional costs

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Allocation of Joint CostsAllocation of Joint Costs

For financial reporting, the cost of common inputs must be allocated to the joint products The total joint cost will be incurred no matter

what the company does with the joint products beyond the split-off point

The joint cost is not incremental to production of an individual joint product and irrelevant to decisions regarding an individual joint product


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Joint Products ExampleJoint Products Example


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Joint Cost Allocation Methods Joint Cost Allocation Methods

Physical quantity of output

Joint costs allocated to product A =

Joint costs allocated to product B =

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Joint Cost Allocation Example Joint Cost Allocation Example

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Joint Cost Allocation Methods Joint Cost Allocation Methods

Relative sales value

Joint costs allocated to product A =

Joint costs allocated to product B =

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Joint Cost Allocation Example Joint Cost Allocation Example

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Additional Processing Decisions and Joint Costs

Additional Processing Decisions and Joint Costs

Joint costs not relevant to decisions made after the split-off point because they are not incremental

Joint costs incurred prior to the split-off point are sunk costs and have no effect on what happens after the split-off point


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The joint costs incurred in a joint product situation:

a. Are incurred before the split-off pointb. Are incurred after the split-off pointc. Should only be allocated based on

physical attributesd. Should never be allocated

Answer: aAre incurred before the split-off point


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Qualitative Considerations in Decision Analysis


Many decisions have one or more features that are difficult to quantify but should be given careful consideration

Examples include, but are not limited to Swings in the economy Loss of control Quality of the product Quality of service Company morale

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Qualitative FactorsQualitative Factors


Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).

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Appendix – The Theory of Constraints


The Theory of Constraints is an approach to production and constraint management developed by Eli Goldratt Five step process Large increases in profit can be achieved

by elimination of bottlenecks in production processes


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Goldratt specified a five step process for dealing with constraints

1. Identify the Binding ConstraintThe binding constraint is the process that limits throughput

2. Optimize Use of the ConstraintProduce products with the highest contribution margin per unit of the constraint


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3. Subordinate Everything Else to the ConstraintManagers should focus their attention on trying to loosen the constraint and not on process improvements


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4. Break the ConstraintThis can be done many ways including cross training workers, outsourcing, purchasing additional equipment or hiring new workers

5. Identify a New Binding ConstraintIdentify the additional bottlenecks. If there are no bottlenecks and excess capacity, focus on building demand


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Implications of The Theory of Constraints

Implications of The Theory of Constraints

Inspections Should take place before work is transferred to a

constrained department Batch sizes

When a production process is a binding constraint, it may be better to have large batch sizes The time of the constrained department is not

wasted setting up equipment for numerous batches Across the board cuts

Cuts in bottleneck departments may make sense, but across the board cuts can have a serious negative impact on profits


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You Get What You Measure and The Theory of Constraints

You Get What You Measure and The Theory of Constraints

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Prepared by Debby Bloom-Hill CMA, CFM. Slide 7-2 CHAPTER 7 The Use of Cost Information in Management Decision Making