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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
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
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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:
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
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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.
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.
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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:
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.
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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.
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
ii. Assume a segmented income statement for
the digital watches line is as shown. Also,
assume the following:
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2. The equipment used to manufacture digital
watches has no resale value or alternative
use.
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.
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.
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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?”
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.
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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
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.
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?
1. The depreciation of special equipment
represents a sunk cost. Furthermore, the
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.
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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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 4: Prepare an analysis showing
whether a special order should be accepted.
A. Key terms and concepts
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.
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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
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 5: Determine the most profitable
use of a constrained resource.
A. Key terms and concepts
i. When a limited resource of some type
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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.
ii. Fixed costs are usually unaffected in these
situations, so the product mix that
maximizes the company’s total
contribution margin should ordinarily be
i. Assume that Ensign Company produces
two products and selected data are as
shown. In addition assume that:
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1. Machine A1 is the constraint.
2. There is excess capacity on all other
Quick Check – constrained resource calculations
ii. As suggested by the answer to the Quick
Check question, Ensign should emphasize
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
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Learning Objective 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?
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:
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ii. These methods and ideas are all consistent
with the Theory of Constraints, which
was introduced in Chapter 1.
VI. Joint product costs and the contribution approach
Learning Objective 7: Prepare an analysis showing
whether joint products should be sold at the split-off
point or processed further.
A. Key terms/concepts
i. In some industries, a number of end
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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.
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.
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
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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.
D. Activity-based costing and relevant costs
1. Activity-based costing can be used to help
identify potentially relevant costs for
decision-making purposes. However,
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