Chapter 12 – Lecture Notes
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Chapter 12
Lecture Notes
Chapter theme: Making decisions is one of the basic
functions of a manager. To be successful in decision
making, managers must be able to perform differential
analysis, which focuses on identifying the costs and
benefits that differ between alternatives. The purpose of
this chapter is to develop these skills by illustrating their
use in a wide range of decision-making situations.
I. Cost concepts for decision making
Learning Objective 1: Identify relevant and irrelevant
costs and benefits in a decision.
A. Identifying relevant costs and benefits
i. Costs that differ between alternatives are
called relevant costs. Benefits that differ
between alternatives are relevant benefits.
1. An avoidable cost is a cost that can be
eliminated in whole or in part by choosing
one alternative over another. Avoidable
costs are relevant costs. Unavoidable costs
are irrelevant costs.
ii. Two broad categories of costs are never
relevant in any decision:
1. A sunk cost is a cost that has already been
incurred and cannot be avoided regardless of
what a manager decides to do.
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2. A future cost that does not differ between
alternatives is never relevant in a decision.
iii. Keys to successful decision-making:
1. Focus only on relevant costs (also called
avoidable costs, differential costs, or
incremental costs) and relevant benefits
(also called differential benefits or
incremental benefits).
2. Ignore everything else including sunk costs
and future costs and benefits that do not
differ between the alternatives.
iv. Different costs for different purposes
1. Costs that are relevant in one decision
situation may not be relevant in another
context. Thus, in each decision situation, the
manager must examine the data at hand and
isolate the relevant costs.
B. An example of identifying relevant costs and
benefits
i. Assume the following information with
respect to Cynthia, a Boston student who is
considering visiting her friend in New
York. Cynthia is trying to decide whether
it would be less expensive to drive or take
the train to New York.
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1. She has assembled the following
information with respect to her automobile.
2. She has also gathered the additional
information as shown to aid in her decision.
3. Which costs are relevant to her decision?
a. The cost of the car is irrelevant to the
decision because it is a sunk cost.
b. The annual cost of auto insurance is
irrelevant because it does not differ
between alternatives.
c. The cost of the gasoline is relevant
because it is avoidable if she takes the
train.
d. The cost of maintenance and repairs is
relevant because in the long-run these
costs depend upon miles driven.
e. The parking fee at school is irrelevant
because it is not a differential cost.
f. The decline in resale value is relevant
due to the additional miles driven.
g. The round trip train fare is relevant
because it is avoidable if she drives her
car.
h. Relaxing on the train is relevant, but
difficult to quantify.
i. The kennel cost is irrelevant because
it is not a differential cost.
j. The cost of parking in New York is
relevant because it is avoidable if she
takes the train.
k. The benefits of having a car in New
York and the problem of finding a
parking space are both relevant, but
difficult to quantify.
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4. From a financial standpoint, Cynthia would
be better off taking the train.
C. Reconciling the total and differential approaches
i. Assume the following information for a
company considering a new labor-saving
machine that rents for $3,000 per year.
Notice:
1. The total approach requires constructing two
contribution format income statements –
one for each alternative.
2. The difference between the two income
statements of $12,000 equals the differential
benefits shown at the bottom of the right-
hand column.
3. The most efficient means of analyzing this
decision is to use the differential approach
to isolate the relevant costs and benefits as
shown.
ii. Using the differential approach is desirable
for two reasons:
1. Only rarely will enough information be
available to prepare detailed income
statements for both alternatives.
2. Mingling irrelevant costs with relevant costs
may cause confusion and distract attention
away from the information that is really
critical.
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II. Adding and dropping product lines and other segments
Learning Objective 2: Prepare an analysis showing
whether a product line or other business segment
should be added or dropped.
A. One of the most important decisions managers make is
whether to add or drop a business segment.
Ultimately, a decision to drop an old segment or add a
new one is going to hinge primarily on the impact the
decision will have on net operating income. To assess
this impact it is necessary to carefully analyze the costs.
B. Lovell Company – an example
i. Assume that Lovell Company’s digital
watch line has not reported a profit for
several years; accordingly, Lovell is
considering discontinuing this product
line.
1. To determine how dropping this line will
affect the profits of the company, Lovell will
compare the contribution margin that
would be lost to the costs that would be
avoided if the line was to be dropped.
ii. Assume a segmented income statement for
the digital watches line is as shown. Also,
assume the following:
1. An investigation has revealed that the fixed
general factory overhead and fixed general
administrative expenses will not be affected
by dropping the digital watch line.
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2. The equipment used to manufacture digital
watches has no resale value or alternative
use.
iii. A contribution margin approach reveals that
the contribution margin lost ($300,000)
exceeds the fixed costs avoided ($260,000) by
$40,000. Therefore, Lovell should retain the
digital watch segment.
iv. Comparative income statements can also be
prepared to help make the decision.
1. These income statements show that if the
digital watch line is dropped, the company
loses $300,000 in contribution margin.
2. The general factory overhead ($60,000)
would be the same under both alternatives,
so it is irrelevant.
3. The salary of the product line manager
($90,000) would disappear, so it is relevant
to the decision.
4. The depreciation ($50,000) is a sunk cost.
Also, remember that the equipment has no
resale value or alternative use, so the
equipment and the depreciation expense
associated with it are irrelevant to the
decision.
5. The complete comparative income
statements reveal that Lovell would earn
$40,000 of additional profit by retaining the
digital watch line.
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v. Lovell’s allocated fixed costs can distort the
keep/drop decision.
1. Lovell’s managers may ask “why keep the
digital watch segment when its segmented
income statement shows a $100,000 loss?”
2. The answer lies in the way common fixed
costs are allocated to products.
a. Including unavoidable common fixed
costs in the segmented income
statement makes the digital watch
product line appear to be unprofitable,
when in fact dropping the product line
would decrease the company’s overall
net operating income.
III. The make or buy decision
Learning Objective 3: Prepare a make or buy analysis.
A. Key terms and strategic aspects
i. When a company is involved in more than
one activity in the entire value chain, it is
vertically integrated.
1. A decision to carry out one of the activities
in the value chain internally, rather than to
buy externally from a supplier, is called a
make or buy decision.
Helpful Hint: Some critics charge that managers have
habitually based make or buy decisions on per unit data
without determining which costs are relevant and which
are not. Since the per unit costs typically include
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allocated common fixed costs, they overstate the costs
of producing internally. This creates a bias in favor of
outsourcing production.
ii. Vertical integration provides certain
advantages:
1. An integrated company may be able to
ensure a smoother flow of parts and
materials for production than a
nonintegrated company.
2. Some companies feel that they can control
quality better by producing their own parts
and materials.
3. Integrated companies realize profits from
the parts and materials that they choose to
make instead of buy.
iii. The primary disadvantage of vertical
integration is that a company may fail to
take advantage of suppliers who can create
an economies of scale advantage by
pooling demand from numerous
companies.
1. While the economies of scale factor can be
appealing, a company must be careful to
retain control over activities that are
essential to maintaining its competitive
position.
B. Essex Company – an example
i. Assume that Essex Company manufactures
part 4A with a unit product cost as shown.
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1. Also, assume the following information as
shown with respect to part 4A. Given these
additional assumptions, should Essex make
or buy part 4A?
ii. The avoidable costs associated with
making part 4A include direct materials
($180,000), direct labor ($100,000),
variable overhead ($20,000), and the
supervisor’s salary ($40,000). Notice:
1. The depreciation of special equipment
represents a sunk cost. Furthermore, the
equipment has no resale value, thus the
special equipment and its associated
depreciation expense are irrelevant to the
decision.
2. The general factory overhead represents
future costs that will be incurred regardless
of whether Essex makes or buys part 4A;
hence, it is also irrelevant to the decision.
iii. The total avoidable costs of $340,000 are
less than the $500,000 cost of buying the
part, thereby suggesting that Essex should
continue to make the part.
C. Opportunity cost
i. An opportunity cost is the benefit that is
foregone as a result of pursuing a course
of action. These costs do not represent
actual cash outlays and they are not
recorded in the formal accounts of an
organization.
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