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Chapter 10 Lecture Notes
1
Chapter 10
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 10-1: 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 10-2: 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 10-3: 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 often
base make or buy decisions on per unit data without
determining which costs are relevant and which are
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not. Since the per unit costs typically include allocated
common fixed costs, they overstate the costs of
producing internally. This creates a bias in favor of
outsourcing production.
B. Essex Company – an example
i. Assume that Essex Company manufactures
part 4A with a unit product cost as shown.
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.
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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.
ii. In the Essex Company example that we
just completed, if Essex had an alternative
use for the capacity that it used to make
part 4A, there would have been an
opportunity cost to factor into the analysis.
1. The opportunity cost would have been equal
to the segment margin that could have
been derived from the best alternative use
of the space.
IV. Special orders
Learning Objective 10-4: Prepare an analysis showing
whether a special order should be accepted.
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A. Key terms and concepts
i. A special order is a one-time order that is
not considered part of the company’s
normal ongoing business.
ii. When analyzing a special order, only the
incremental costs and benefits are
relevant. Since the existing fixed
manufacturing overhead costs would not
be affected by the order, they are not
relevant.
Helpful Hint: Emphasize the incremental concept in the
decision-making process. If a company accepts a
special order to produce an item without carefully
determining existing capacity, it might have to cut into
regular production. The effects of lost sales from
ongoing products might be devastating.
B. Jet Inc. – an example
i. Assume the following information with
respect to a special order opportunity for
Jet Inc. Should Jet accept the offer?
ii. A contribution format income statement
for Jet Inc.’s normal sales of 5,000 units is
as shown.
iii. If Jet accepts the special order, the
incremental revenue of $30,000 will
exceed the incremental costs of $24,000 by
$6,000. This suggests that Jet should
accept the order. Notice:
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1. This answer assumes that the fixed costs are
unavoidable and that variable marketing
costs must be incurred on the special order.
Quick Check – special order decision making
V. Utilization of a constrained resource
Learning Objective 10-5: Determine the most
profitable use of a constrained resource.
A. Key terms and concepts
i. When a limited resource of some type
restricts the company’s ability to satisfy
demand, the company is said to have a
constraint. The machine or process that is
limiting overall output is called the
bottleneck—it is the constraint.
ii.
Helpful Hint: A production process can be thought of
as a chain; each link in the chain represents a step in
the process. A chain is only as strong as its weakest
link. Likewise, the capacity of a production process is
determined by its weakest link, which is the constraint.
To increase the strength of a chain, its weakest link
must be strengthened. To increase the output of the
entire process, the output of the constraint must be
increased. Strengthening the stronger links has no
effect on the strength of the entire chain. The moral is
to identify the constraint and concentrate management
attention on effectively increasing its capacity.
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iii. Fixed costs are usually unaffected in these
situations, so the product mix that
maximizes the company’s total
contribution margin should ordinarily be
selected.
iv. A company should not necessarily promote
those products that have the highest unit
contribution margins. Rather, total
contribution margin will be maximized by
promoting those products or accepting
those orders that provide the highest
contribution margin in relation to the
constraining resource.
B. Ensign Company – an example
i. Assume that Ensign Company produces
two products and selected data are as
shown. In addition assume that:
1. Machine A1 is the constraint.
2. There is excess capacity on all other
machines.
3. Machine A1 has a capacity of 2,400
minutes per week.
4. Ensign is trying to decide if it should focus
its efforts on product 1 or 2.
Quick Check – constrained resource calculations
ii. As suggested by the answer to the Quick
Check question, Ensign should emphasize
product 2 because it generates a
contribution margin of $30 per minute
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of the constrained resource relative to
$24 per minute for product 1.
iii. Ensign can maximize its contribution
margin by first producing product 2 to
meet customer demand and then using any
remaining capacity to produce product
1. The calculations would be performed as
follows:
1. Satisfying the weekly demand of 2,200
units for product 2 would consume 1,100
minutes of available capacity on machine
A1.
2. This implies that 1,300 constraint minutes
would still be available to satisfy demand
for product 1.
3. Since each unit of product 1 requires one
minute of A1 machine time, Ensign could
produce 1,300 units of product 1 with its
remaining capacity.
4. This mix of production (e.g., 2,200 units of
product 2 and 1,300 units of product 1)
would yield a total contribution margin of
$64,200.
Learning Objective 10-6: Determine the value of
obtaining more of the constrained resource.
iv. How much should Ensign be willing to pay
for an additional minute of A1 machine
time?
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1. Because the additional machine time would
be used to make more units of Product 1,
Ensign should be willing to pay up to $24
per minute. This amount equals the
contribution margin per minute of machine
time that would be earned producing more
units of Product 1.
Quick Check – constrained resource calculations
C. Managing constraints
i. It is often possible for a manager to
increase the capacity of a bottleneck,
which is called relaxing (or elevating) the
constraint, in numerous ways such as:
1. Working overtime on the bottleneck.
2. Subcontracting some of the processing that
would be done at the bottleneck.
3. Investing in additional machines at the
bottleneck.
4. Shifting workers from non-bottleneck
processes to the bottleneck.
5. Focusing business process improvement
efforts on the bottleneck.
6. Reducing defective units processed through
the bottleneck.
VI. Joint product costs and the contribution approach
Learning Objective 10-7: Prepare an analysis showing
whether joint products should be sold at the split-off
point or processed further.
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A. Key terms/concepts
i. In some industries, a number of end
products are produced from a single raw
material. When two or more products are
produced from a common input these
products are known as joint products. The
split-off point is the point in the
manufacturing process at which the joint
products can be recognized as separate
products.
1. For example, in the petroleum refining
industry a large number of products are
extracted from crude oil, including gasoline,
jet fuel, home heating oil, lubricants,
asphalt, and various organic chemicals.
ii. The term joint cost is used to describe
costs incurred up to the split-off point.
Joint costs are common costs incurred to
simultaneously produce a variety of end
products.
1. Joint costs are traditionally allocated among
different products at the split-off point. A
typical approach is to allocate joint costs
according to the relative sales value of the
end products.
2. Although allocation is needed for some
purposes such as balance sheet inventory
valuation, allocations of this kind are very
dangerous for decision making.
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B. Sell or process further decisions
i. Joint costs are irrelevant in decisions
regarding what to do with a product from
the split-off point forward. Therefore, these
costs should not be allocated to end
products for decision-making purposes.
ii. With respect to sell or process further
decisions, it is profitable to continue
processing a joint product after the split-off
point so long as the incremental revenue
from such processing exceeds the
incremental processing costs incurred
after the split-off point.
C. Sell or process further decisions – an example
i. Assume the facts as shown with respect to
Sawmill, Inc.
1. Sawmill has two joint products – lumber
and sawdust. Selected financial information
is shown for each joint product.
2. The incremental revenue from further
processing of the lumber and sawdust is
$130 and $10, respectively.
3. The profit (loss) from further processing is
$80 for the lumber and ($10) for the
sawdust.
4. The lumber should be processed further
and the sawdust should be sold at the split-
off point.
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