Decision Making: Relevant Costs and Benefits

CHAPTER 14

Decision Making: Relevant Costs and Benefits

ANSWERS to Review Questions

14-1The six steps in the decision-making process are as follows:

• Clarify the decision
• Specify the criterion
• Identify the alternatives
• Develop a decision model
• Collect the data
• Select an alternative
• The managerial accountant’s role in the decision-making process is to participate as a proactive member of the management team, and, in particular, to provide information relevant to the decision.
• A decision model is a simplified representation of the choice problem. Unnecessary details are stripped away, and the most important elements of the problem are highlighted.
• A quantitative analysis is expressed in numerical terms. A qualitative analysis focuses on the factors in a decision problem that cannot be expressed effectively in numerical terms.
• The result of a quantitative analysis is that one alternative is preferred over the next-best alternative by some numerical amount, such as profit. The amount by which the best alternative dominates the second-best alternative establishes a “price” on the sum total of the qualitative characteristics that might favor the second-best alternative. Suppose, for example, that a hospital’s board of directors is considering establishing an outpatient clinic in one of the two suburban communities. The quantitative analysis of the decision suggests that site A will be more cost effective for the clinic than site B. Assume that the annual cost of running the clinic at site A will be $50,000 less than the annual cost of running the clinic at site B. Now suppose that the board of directors feels that various qualitative considerations indicate that it would be preferable to locate the clinic at site B. For example, suburb B might be an economically depressed area, where it is important to bring better-quality health care to the community. Now the board of directors can put a price on these qualitative advantages to locating the clinic at site B. If the board of directors believes that the qualitative benefits at site B outweigh the $50,000 quantitative advantage at site A, then they should locate the clinic at site B.
• Relevant information is pertinent to a decision problem. Accurate information is precise. Timely information is available to the decision maker in time to make the decision. Objective information need not be relevant or accurate. For example, several people may agree that the interest rate in the coming year in a local community will be 10 percent. However, this information may not be accurate, since that prediction may prove to be wrong. Moreover, information about the interest rate may not be pertinent to a decision about where to locate a new branch bank within the community.
• Two important criteria that must be satisfied in order for information to be relevant are as follows:

(1)Relevant cost or benefit information must involve a future event. In other words, the information must have a bearing on the future.

(2)Relevant information must involve costs or benefits that differ among the alternatives. Costs or benefits that are the same across all of the available alternatives have no bearing on the decision.

14-8The book value of an asset is its acquisition cost less its accumulated depreciation. The book value is not a relevant cost because it is a sunk cost. It occurred in the past and has no bearing on the future.

14-9The book value of inventory, like the book value of any asset, is not a relevant cost. The inventory’s book value is based on its acquisition cost or its production cost and is, therefore, a sunk cost. It has no bearing on any future course of action.

14-10Managers sometimes exhibit a behavioral tendency to inappropriately consider a sunk cost in making a decision, because they believe that their original decision to incur the sunk cost, such as when an asset is acquired, will appear to have been a bad decision if the manager subsequently disposes of the asset. This perceived need by managers for their past decisions to appear to have been good ones may result in their inappropriate emphasis on sunk costs in making a decision.

14-11An example of an irrelevant future cost is a cost that will occur in the future but does not differ among the alternatives. For example, a bank may be considering several sites for the location of a new branch office. If the cost of hiring an architect to design the new building will not differ among the alternatives, it is an irrelevant future cost.

14-12An opportunity cost is the potential benefit given up when the choice of one action precludes a different action. For example, one opportunity cost associated with getting a college education is the student’s forgone wages from a job that might have been held during the educational period.

14-13People often exhibit a behavioral tendency to ignore or downplay the importance of opportunity costs in making a decision. Since an opportunity cost often is not a cash flow, people tend to think it is less important than costs that are represented by cash flows. This behavioral tendency can result in faulty decision making.

14-14If a firm has excess production capacity, there is no opportunity cost to the acceptance of a special order. On the other hand, if the firm is already at capacity and there is no excess production capacity, the opportunity cost associated with accepting a special order involves the contribution margin from the products that would have been manufactured with the resources devoted to the special order.

14-15In a differential-cost analysis, the decision maker determines the difference in each cost or revenue item that will occur under each of the alternatives under consideration. Then the decision maker focuses on the differences in the costs and revenues in making the decision.

14-16In making a decision about adding or dropping a product line, the decision maker should consider the avoidable expenses if the product line is not carried as well as the impact of the decision to add or drop the product line on the firm’s other operations.

14-17A joint production process is one in which the processing of a common input results in two or more distinct products known as joint products. A special decision that commonly arises in the context of the joint production process is the decision whether or not to process further one of the joint products into a different product. The proper approach for making this type of decision is to compare the incremental benefits from further processing with the incremental costs.

14-18The allocated joint processing costs are irrelevant when making a decision as to whether a joint product should be sold at the split-off point or processed further. The total joint cost will not change as a result of the decision to process further, and therefore it is irrelevant to the decision.

14-19The proper approach to making a production decision when limited resources are involved is to maximize production of the product that has the highest contribution margin per unit of scarce resource. When two or more resources are limited, the technique of linear programming may be appropriate.

14-20The contribution margin per unit of scarce resource is a product’s unit contribution margin divided by the number of units of the scarce resource required to produce one unit of the product. For example, if a product’s contribution margin per unit is $5 and it requires two hours of labor to produce one unit, the contribution margin per direct-labor hour is $2.50.

14-21Sensitivity analysis may be used to cope with uncertainty in decision making by analyzing how sensitive a decision problem is to the estimates of certain parameters. One important question that can be answered is; How much can a particular parameter estimate change before the optimal decision changes?

14-22There is an important link between decision making and managerial performance evaluation, because managers typically make decisions that maximize their perceived performance evaluations and rewards. If we want managers to make optimal decisions by properly evaluating the relevant cost and benefits, then the performance evaluation system and reward structure must be consistent with that goal.

14-23Four potential pitfalls in decision making that represent common errors are the following:

(1)Paying too much attention to sunk costs.

(2)Basing the analysis on unitized fixed costs rather than total fixed costs. Using unitized fixed costs is dangerous because the fixed cost per unit changes as activity changes.

(3)Not identifying avoidable costs. In some kinds of decisions, it is important to identify the avoidable costs. It is critical that the decision maker make a distinction between the amount of the fixed costs that will be avoided and the amount that may have been arbitrarily allocated to a particular cost object.

(4)Overlooking opportunity costs or treating them as less important than out-of-pocket costs. In a decision analysis, it is important to pay special attention to identifying and including opportunity costs.

14-24Unitized fixed costs can cause errors in decision making because the fixed cost per unit changes as the activity measure changes. For this reason, it is better to include fixed costs in the analysis in their total amounts.

14-25Sunk costs are irrelevant in decision making because they have already occurred in the past and will not change under any future, alternative course of action. Two examples of sunk costs are the book value of equipment and the book value of inventory on hand.

14-26This remark fails to recognize the fact that the identification of relevant information depends on the decision. Data that are relevant to one decision may be irrelevant to another one. Therefore, it would be impossible for the managerial-accounting system to produce only information that is relevant to all decisions.

14-27The concepts underlying a relevant-cost analysis remain valid both in an advanced manufacturing environment and in a situation where activity-based costing is used. However, when an ABC system is used, the decision maker typically is able to more accurately determine the relevant costs than when a traditional, volume-based costing system is used.

14-28Five ways to relax a bottleneck constraint are as follows:

• Working overtime at the bottleneck operation.
• Retraining employees and shifting them to the bottleneck.
• Eliminating any non-value-added activities at the bottleneck operation.
• Outsourcing (subcontracting) all or part of the bottleneck operation.
• Investing in additional production equipment and employing parallel processing, in which multiple product units undergo the same production operation simultaneously.

Solutions to exercises

Exercise 14-29 (25 minutes)

Students’ answers to this exercise will vary widely. The following illustration is set in a small city in central New York. Residents of an outlying suburb of the city complained that it took too long for ambulances and fire engines to reach their area when emergencies occurred. They demanded that the city build a satellite fire and rescue station in their neighborhood. The steps in the city’s decision-making process are summarized as follows:

QUANTITATIVE ANALYSIS

1.Clarify the decision problem: The first step was to clarify the problem. Was the perceived slow response time real or merely a perception by the residents of the neighborhood? What was the average response time for emergency vehicles to the area? Were proper procedures being followed? What was the condition of the roads, bridges, and traffic lights on the route to the neighborhood in question?

The result of this inquiry was a realization that the emergency response time to the suburb was slower than that experienced by the rest of the city, although it was still within state guidelines. Moreover, procedures were being followed properly by emergency personnel, and the traffic system was adequate for emergency responses. The conclusion of the problem clarification stage was that the neighborhood was simply too far from the city’s fire and rescue station to respond as quickly as the residents of the neighborhood would have liked.

1. Specify the criterion: The City Council decided that some type of action was warranted. They specified that the city engineer should find a way to cut response time to the neighborhood by five minutes without incurring unacceptable costs.
2. Identify the alternatives: The city engineer identified the following alternatives:

1. Build a satellite fire and rescue station on the west end of the affected neighborhood.
2. Station two fire trucks and an ambulance, along with the requisite personnel, in the parking lot of a shopping center in the suburb.

1. Develop a decision model: The decision model consisted of a computer program that would simulate emergency response times and costs under each of the two alternatives.

exercise 14-29 (continued)

1. Collect the data: The data needed for the decision model included employee compensation data, acquisition and maintenance costs for a satellite station, and the projected costs of operating the new station.

QUALITATIVE CONSIDERATIONS

The computer model indicated that either alternative would satisfy the criterion of reducing emergency response times by five minutes, and that the positioning of emergency vehicles at the shopping center would be less expensive. Nevertheless, the City Council felt that this solution would be perceived by the residents of the neighborhood as a temporary, stopgap measure that did not really address their needs.

1. Make a decision: The City Council decided to build a satellite fire and rescue station. Although this alternative was somewhat more expensive, the Council felt that the qualitative considerations outweighed the cost advantage of the other alternative.

Exercise 14-30 (20 minutes)

Flight Route Decision

Revenues and Costs
Under Two Alternatives
(a)
Nonstop
Route* / (b)
With Stop
In San
Francisco* / (c)
Differential
Amount†
Passenger revenue ...... / $240,000 / $258,000 / $(18,000 / )
Landing fee in San Francisco ...... / -0- / (5,000 / ) / 5,000
Use of airport gate facilities ...... / -0- / (3,000 / ) / 3,000
Flight crew cost ...... / (2,000 / ) / (2,500 / ) / 500
Fuel ...... / (21,000 / ) / (24,000 / ) / 3,000
Meals and services ...... / (4,000 / ) / (4,600 / ) / 600
Total revenue less costs ...... / $213,000 / $218,900 / $ (5,900 / )

*In columns (a) and (b), parentheses denote costs, and numbers without parentheses are revenues.

†In column (c), parentheses denote differential items favoring option (b).

Exercise 14-31 (15 minutes)

1. / The owner’s reasoning probably reflects the following calculation:
Savings in annual operating expenses if old pizza oven is replaced / $2,600
Write-off of old oven’s remaining book value ($9,000 ÷ 3) ..... / (3,000 / )
“Loss” associated with replacement ...... / $ (400 / )
2. / The owner’s analysis is flawed, because the book value of the old pizza oven is a sunk cost. It should not enter into the equipment replacement decision.
3. / Correct analysis:
Savings in annual operating expenses if old pizza oven is replaced / $2,600
Acquisition cost of new oven, which will be operable for one year / (1,900 / )
Net benefit from replacing old pizza oven ...... / $ 700

Exercise 14-32 (15 minutes)

Dear (president’s name):

We recommend against processing banolide into kitrocide. The incremental cost of further processing, $8,100, exceeds the incremental revenue, $7,500. This $7,500 incremental revenue is the difference between the sales value of the kitrocide, $10,000, and the sales value of the banolide, $2,500. We would also like to point out that the cost of the joint process, $19,000, and the allocation of that cost to the joint products is irrelevant to the decision.

Sincerely,

I.M. Student
Partner, Student Consulting Associates

Exercise 14-33 (15 minutes)

The owner’s analysis incorrectly includes the following allocated costs that will be incurred regardless of whether the ice cream counter is operated:

Utilities ...... / $2,900
Depreciation of building ...... / 4,000
Deli manager’s salary ...... / 3,000
Total ...... / $9,900

It is possible that closing the ice cream counter might save a portion of the utility cost, but that is doubtful.

A better analysis follows:
Sales ...... / $45,000
Less: Cost of food ...... / 20,000
Gross profit ...... / 25,000
Less:Operating expenses
Wages of counter personnel ...... / $12,000
Paper products ...... / 4,000
Depreciation of counter equipment and furnishings* / 2,500
Total ...... / 18,500
Profit on ice cream counter / $ 6,500
*Depreciation on the counter equipment and furnishings is included because it is traceable to the ice cream operation and is an expense in the determination of income. If a cash-flow analysis is desired, this noncash expense should be excluded.

EXERCISE 14-34 (30 MINUTES)

Answers will vary depending on the company and activity chosen. There are many trade-offs involved in outsourcing decisions, including the incremental savings or cost from outsourcing, quality of the service, reliability of the supplier, morale effects if outsourcing results in closing a department, and so forth.

Exercise 14-35 (15 minutes)

1. / Relevant data:
Current sales value for unmodified parts ...... / $9,000
Sales value for modified parts ...... / 22,300
Modification costs ...... / 12,000
Irrelevant data:
Current book value of inventory ...... / 21,000
This is a sunk cost. It will not affect any future course of action.
2. / There are two alternatives for disposing of the obsolete parts: (a) sell in unmodified condition or (b) modify and then sell.
(a)Benefit if parts are sold without modification ...... / $9,000
(b)Sales value for modified parts ...... / $22,300
Cost of modification ...... / 12,000
Net benefit if parts are sold after being modified ...... / $10,300
Conclusion: Modify the parts and then sell them.

Exercise 14-36 (15 minutes)

1. / The relevant cost of the theolite to be used in producing the special order is the 14,500p sales value that the company will forgo if it uses the chemical. This is an example of an opportunity cost.
p denotes Argentina’s peso.
2. / (a)14,500p sales value: Discussed in requirement (1).
(b)16,000p book value (8,000 kilograms  2p per kilogram): Irrelevant, since the
book value is a sunk cost.
(c)19,200p current purchase cost (8,000 kilograms  2.40p per kilogram): Irrelevant, since the company will not be buying any theolite.

Exercise 14-37 (20 minutes)

1. / The relevant cost of genatope is calculated as follows:
Cost of replacing the 1,000 kilograms to be used in the special order
(1,000 kilograms  8.70p) ...... / 8,700p
*Additional cost incurred on the next order of genatope as a result of
having to place the order early [4,000 kilograms  (8.70p – 8.30p)] / 1,600p
Total relevant cost ...... / 10,300p
p denotes Argentina’s peso.
*This cost would not be incurred if the special order were not accepted.
2. / (a) 64,800p book value (8,000 kilograms  8.10p per kilogram): Irrelevant, since it is a sunk cost.
(b)1,000 kilograms to be used in the special order: Relevant, as shown in requirement (1).
(c)8.70p price if next order is placed early: Relevant, since this is the cost of replacing the used genatope.
(d)8.30p price if next order is placed on time: Relevant, because an additional 4,000 kilograms in the next order will be purchased at a .40p per kilogram premium. This .40p premium is the difference between the 8.70p price and the 8.30p price.

Exercise 14-38 (15 minutes)

1. / (a)$9,100 allocation of rent on factory building: Irrelevant, since Fusion Metals Company will rent the entire factory building regardless of whether it continues to operate the Packaging Department. If the department is eliminated, the space will be converted to storage space.
(b)$11,000 rental of storage space in warehouse: Relevant, since this cost will be incurred only if the Packaging Department is kept in operation. If the department is eliminated, this $11,000 rental cost will be avoided.
2. / The $11,000 warehouse rental cost is the opportunity cost associated with using space in Fusion Metals Company’s factory building for the Packaging Department.

Exercise 14-39 (15 minutes)