CHAPTER
16
Costs for Decision Making
CHAPTER OUTLINE:
I. Cost Classifications
A. Classifications for Other Analytical Purposes
2. Allocated cost
4. Opportunity cost
II. Short Run Decision Analysis
A. Relevant Costs
B. Irrelevant Costs
C. The Sell or Process Further Decision
D. The Special Pricing Decision
E. The Target Costing Question
F. The Make or Buy Decision
G. The Continue or Discontinue a Segment Decision
H. Short-Term Allocation of Scarce Resources
III. Capital Budgeting
A. Investment Decision Special Considerations
2. Involvement of Board of Directors
B. Cost of Capital
C. Capital Budgeting Techniques
1. Methods that use present value analysis
2. Some analytical considerations
a. Estimates
b. Cash flows far into the future
Chapter 16 Costs for Decision Making
CHAPTER OUTLINE: (continued)
3. Methods that do not use present value analysis
a. Payback
b. Accounting rate of return
D. The Investment Decision
TEACHING/LEARNING OBJECTIVES:
Primary: To have the student understand:
1. And appreciate the difference in relevant cost analysis for short-run decisions, such as the
2. That capital budgeting deals with cash flows from activities that extend relatively far into the
future, and that the application of present value techniques is necessary and appropriate.
4. That in addition to quantitative approaches to decision-making, management is also
influenced by qualitative factors.
Supporting: To have the student understand:
5. That whether the firm is operating at full capacity or idle capacity will affect the special
pricing decision.
6. That a number of short-term decisions are a function of relevant cost analysis such as the sell
8. That the internal rate of return analytical method is really a special case of the NPV method
that solves for a discount rate at which NPV is equal to zero.
10. Some of the analytical considerations involved in capital budgeting.
11. How capital budgeting is integrated with operational budgeting discussed in Chapter 14.
Instructor’s Manual / Solutions Manual
TEACHING OBSERVATIONS:
1. It is important that students understand that relevant cost analysis used to support short run
decisions is a “way of thinking” that focuses only on the incremental revenues and
2. Emphasize that capital budgeting deals with time periods that can extend far into the future,
3. An interesting way of illustrating capital budgeting, and adding some of the qualitative issues
involved, is to develop an analysis based on a student’s investment in his/her college
4. It is recommended that a time-line format be used for explaining and illustrating the cash
flows related to an investment, because this emphasizes the appropriateness of present value
analysis.
ASSIGNMENT OVERVIEW:
NO.
DIFFICULTY &
TIME ESTIMATE
OTHER COMMENTS
M16.2
Easy, 5-8 min.
Basic introduction to the special pricing decision.
M16.3
Easy, 5-8 min.
Basic introduction to the make or buy decision.
M16.4
Med., 10-12 min.
Introduction to net present value calculation.
M16.6
Med., 12-18 min.
Introduction to payback period and accounting rate of return
calculations.
E16.8
Easy, 3-5 min.
Good in-class exercise.
E16.9
Easy, 3-5 min.
Simple exercise that illustrates incremental analysis.
E16.10
Med., 12-18 min.
Similar to 16.19 and extends the incremental analysis concept.
E16.11
Med., 10-12 min.
Can be used to illustrate one of the potential pitfalls of unitizing
fixed costs.
E16.12
Med., 10-12 min.
See 16.11.
E16.13
Med., 10–12 min.
Straight-forward exercise can be used to introduce the concept
of target costing.
E16.14
Med., 12-18 min.
Expands target costing questions introduced in 16.7.
E16.15
Med., 10-12 min.
Good in-class exercise.
E16.16
Med., 12-18 min.
Similar to 16.15 and extends the make or buy analysis.
E16.18
Med., 12-18 min.
Similar to 16.17 and extends the scarce resource allocation
decision.
Chapter 16 Costs for Decision Making
ASSIGNMENT OVERVIEW: (continued)
NO.
DIFFICULTY &
TIME ESTIMATE
OTHER COMMENTS
E16.19
Med., 7-10 min.
Good self-study/review problem.
E16.20
Med., 7-10 min.
See 16.19. Good in-class exercise.
E16.21
Easy, 5-8 min.
Ask students to review the solution and then to explain the
answer to each part “in your own words.”
E16.23
Med., 7-10 min.
Straight-forward numbers-oriented problem.
E16.24
Med., 12-18 min.
E16.25
Easy, 3-5 min.
Simple conceptual problem.
E16.26
Med., 12-18 min.
assigning this one.
Group learning problem. Students find it difficult to come up
P16.27
Med., 20-25 min.
“way of thinking” about the incremental revenues vs. the
Stress that relevant cost analysis for short-run decisions is a
P16.28
Med., 30-45 min.
See 16.27.
P16.29
Med., 25-30 min.
Straight-forward introduction to the continue or discontinue a
P16.30
Med., 30-40 min.
Similar to 16.29 but includes the analysis of a segmented
P16.31
Med., 10-12 min.
Straight-forward numbers-oriented problem.
P16.32
Med., 12-18 min.
demonstration problem.
P16.33
Easy, 5-8 min.
Students should review solution to this problem before
attempting 16.34.
P16.34
Med.-Hard
15-20 min.
emphasized.
P16.36
Med., 20-30 min.
See 16.35.
C16.37
7
Hard, 75-90 min.
Group learning problem. Perhaps the most complex and
25-35 min.
numbers-oriented problem.
60-75 min.
effectively as group project to analyze Campbell’s annual
reports for a period of three years in terms of their strategy for
Instructor’s Manual / Solutions Manual
SOLUTIONS:
M16.1.
Relevant cost analysis:
Incremental selling price ($40 – $36)……………..…………………….…
$ 4.00
Incremental costs of further processing for material and labor ….…….…
(4.40)
[($10 + $12) * 20%]
Incremental Loss…………………………………..…………………….…
produced and sold as it is currently.
M16.2.
Relevant cost analysis:
Revenue………………………………………..………………
$ 30.00
Direct materials……………………………………….………
$ 10.00
Direct labor……………………………………………………
Variable overhead…………………………………………….
Fixed overhead………………………………………………..
Contribution margin per unit………………………………..…
Additional units sold if special order is accepted………..…….
Increase in contribution margin and operating income……
M16.3.
Relevant cost analysis:
Current
Production
Costs
Avoidable
Cost if Purchased
Cost
to Buy
Manufacturing costs:
Direct material……………………
$10.00
$0.00
Direct labor……………………….
12.00
(30%) 3.60
Variable overhead………………..
$32.00
Purchase costs:
Conversion processing…….………
$4.00
Advantage to buy….………………
However, pertinent qualitative factors should also be considered.
M16.4.
$ 23,523 net present value
0 1 2 3 4 5
Investment………… $(450,000)
Annual cash savings………………..…$120,000 per year
Salvage value…………………………………………………….. $30,000
M16.5.
Present Value Ratio = Present value of cash inflows / Investment
= $473,523 / $450,000 = 1.05
Note: Solving for the IRR indicates a return of approximately 12%.
M16.6.
Payback period = 3.75 years
Investment…………………………………………………………………
$(450,000)
Total return in years 1-3 ($120,000 annual cash flow * 3 years)…………
360,000
Return required in year 4 ($90,000 / $120,000 = 0.75 years)……………
Total return in 3.75 years ………………………………………………
E16.7.
a.
Differential cost: What costs will differ if a friend comes along?
b.
Allocated cost: How to allocate? Based on number of people, weight, number of
suitcases, or what?
Sunk cost: What costs have already been incurred and cannot be recovered, even if you
don’t make the trip? For example, the cost of the car is a sunk cost.
cost of alternative travel for your classmate?
E16.8.
a.
Sunk cost: tuition for prior semesters.
b.
c.
d.
e.
E16.9.
Differential cost analysis:
Incremental selling price ($36 – $29)………
$ 7
Incremental costs of further processing……
($40,000 / 5,000 gallons)
Incremental Profit…………………………..
will result in a decrease in profits of $5,000 (5,000 gallons x $1 incremental loss).
E16.10.
a.
Tons
Alpha production:
175,000
Delta product yield (175,000 x 60%)……..
105,000
Pi product yield (175,000 x 40%)…………
70,000
Differential cost analysis – Super Delta:
Incremental selling price ($18 – $12)…….…
$ 6
Incremental costs of further processing……
($840,000 / 105,000 gallons)
Incremental Profit…………………………..
Differential cost analysis – Precision Pi:
Incremental selling price ($35 – $25)………
$10
Incremental costs of further processing……
($560,000 / 70,000 gallons)
Incremental Profit…………………………..
b.
The $525,000 cost incurred to produce the Alpha ore is a sunk cost and is not relevant
to the decision to sell Delta or Pi as is or process either product further.
E16.10.
(continued)
c.
Sales:
Delta ($12 x 105,000 tons)…………..……………..…..
$1,260,000
Precision Pi ($35 x 70,000 tons)……………………….
2,450,000
$3,710,000
Production costs:
Alpha ore mining costs…………………………………
Processing Pi into Precision Pi…………………………
560,000
Maximum profit………………………………………….
E16.11.
Raw materials per unit ……………………………………………………
$1.50
a.
Direct labor per unit ………………………………………………………
1.50
Variable overhead per unit…………………………………………………
2.00
Fixed overhead per unit ……………………………………………………
Total cost per unit …………………………………………………………
$7.00
b.
range, total fixed expenses will not change.
unit (revenue of $6 per unit less variable cost of $5 per unit).
The above calculation includes an inappropriate unitization of fixed expenses. Unless
E16.12.
a.
Revenue…………………………………………………………………….
$ 15.75
Variable expense……………………………………………………………
(11.90)
Contribution margin per unit……………………………………………….
$ 3.85
Additional units sold if special order is accepted…………………………..
14,000
Increase in contribution margin and operating income………………..
$53,900
more than the selling price for the special order.
this transaction be in violation of federal price discrimination laws?
E16.13.
a.
EagleEye Company would consider the following costs as relevant to the decision to
enter the digital binocular market: design and engineering costs, new equipment, raw
materials, direct labor, variable overhead, any possible new fixed overhead costs such
b.
Target cost = Selling price – Desired profit
Target cost = ($98 * 15,000) – ($3,750,000 * .12)
E16.14.
a.
Current profit margin = Selling price – current cost per cabin
Current profit margin = $2,700 – $2,160 = $540
Current profit margin % = Current profit margin / Selling price
b.
Target cost reduction = Current cost – Target cost
c.
also review operations to make sure processes are efficient. Food and beverage
Rainbow must find ways to reduce its current cost per two-person cabin by $360 in
order to compete at a selling price of $2,160 and earn a 20% profit margin. Rainbow
should look to identify any non-essential activities and eliminate them – if customers
do not perceive value in such activities, then they are not necessary. Rainbow should
E16.15.
Current
Production
Costs
Avoidable
Cost if
Purchased
Cost to Buy
Manufacturing costs:
Direct material……………………
$ 160
$ 160
Direct labor……………………….
80
80
Variable overhead ($80 x 20%)….
16
16
Fixed overhead ($80 x 80%)……..
0
$ 320
$ 256
Purchase costs:
Engine assembly part sets…………
costs they can avoid by buying the part sets are less than the outside purchase cost.
E16.16.
a.
include direct material, direct labor, variable overhead, and the new manager’s salary.
The relevant costs to make the part internally would be the costs that could be avoided
b.
Estimated
Production
Costs
Avoidable
Cost if
Purchased
Cost to Buy
Manufacturing costs:
Direct material……………………
$ 28
$ 28
Direct labor……………………….
12
12
Variable overhead………………..
6
6
Fixed overhead……………………
10
4
$ 56
$ 50
Purchase costs:
Outside purchase cost………..……
Shipping and other costs………….
c.
Other factors that Redbud Company should consider in deciding whether to make this
part internally include the potential for improved control over the availability of the
parts by having it when needed and the potential for improved quality of the parts.