1/31/21 RELEVANT INFORMATION AND DECISION MAKING LECTURE Planning of variable and fixed overhead costs Budgeted variable and fixed overhead rates Learning objectives Variable overhead variances • Spending variance • Efficiency variance Fixed overhead variances • Spending variance • Production volume variance 1/31/21 Decision making process • Relevant information has two characteristics: o It occurs in the future o It differs among the alternative courses of action • Relevant costs—expected future costs • Relevant revenues—expected future revenues Relevance 1/31/21 Relevant Cost Illustration Features of Relevant Information Past (historical) costs are always irrelevant when making decisions Different alternatives can be compared by examining differences in expected total future revenues and expected total future costs Expected future revenues and expected future costs that not differ among alternatives are irrelevant and Appropriate weight must be given to qualitative factors and quantitative nonfinancial factors 1/31/21 Costs that have already occurred and can not be changed are classified as sunk costs Sunk costs Sunk costs are excluded because they can not be changed by future actions Sunk costs are irrelevant in decision making Types of Information Quantitative factors are outcomes that can be measured in numerical terms Qualitative factors are outcomes that are difficult to measure accurately in numerical terms, such as satisfaction Qualitative factors are just as important as quantitative factors even though they are difficult to measure 1/31/21 Terminology Incremental cost— the additional total cost incurred for an activity Differential cost— the difference in total cost between two alternatives Incremental revenue—the additional total revenue from an activity Differential revenue—the difference in total revenue between two alternatives One-time-only special orders Insourcing vs outsourcing Make or buy Types of Decisions Product-mix Customer profitability Branch/segment: adding or discontinuing Equipment replacement 10 1/31/21 Product-Mix Decisions The decisions made by a company about which products to sell and in what quantities Decision rule (with a constraint): Choose the product that produces the highest contribution margin per unit of the constraining resource 11 Product-Mix Decisions – Example – P11-42 WechslerCompanyproducesthreeproducts: A130,B324,and C587 All three products use the same direct material, Brac Unit data for the three products are: The demand for the products far exceeds the direct materials available to produce the products Brac costs $9 per pound, and a maximum of 5,000 pounds is available each month Wechsler must produce a minimum of 200 units of each product How many units of product A130, B324, and C587 should Wechsler produce? What is the maximum amount Wechsler would be willing to pay for another 1,200 pounds of Brac? 12 1/31/21 Adding or Dropping Customers Decision rule: Does adding or dropping a customer add operating income to the firm? Yes—add or don’t drop No—drop or don’t add Decision is based on profitability of the customer, not how much revenue a customer generates 13 Adding or Dropping Customers – Example P11-47 The equipment has a zero disposal value Guide wages, supplies, and vehicle fuel are variable costs Administrative salaries are fixed costs The president is considering dropping the deluxe tour and offering only the basic tour If the deluxe tours are discontinued, one admin position could be eliminated, saving $50,000 Assuming no change in the sales of basic tours, what effect would dropping the deluxe tour have on the company’s operating income? 14 1/31/21 Customer Profitability Analysis- Illustrated 15 Customer Profitability Analysis- Illustrated 16 1/31/21 Sometimes difficult due to amount of information at hand that is irrelevant: EquipmentReplacement Decisions Cost, accumulated depreciation, and book value of existing equipment Any potential gain or loss on the transaction—a financial accounting phenomenon only Decision rule: Select the alternative that will generate the highest operating income 17 Equipment-Replacement Decisions – Example P11-50 18 1/31/21 Equipment-Replacement Decisions – Example P11-50 • Sanchez uses straight-line depreciation on all equipment Annual depreciation expense for the old machine is $180,000 and will be $270,000 on the new machine if it is acquired For simplicity, ignore income taxes and the time value of money • 19 Behavioral Implications Despite the quantitative nature of some aspects of decision making, not all managers will choose the best alternative for the firm Managers could engage in self-serving behavior such as delaying needed equipment maintenance in order to meet their personal profitability quotas for bonus consideration 20 10 ... many units of product A 130 , B324, and C587 should Wechsler produce? What is the maximum amount Wechsler would be willing to pay for another 1,200 pounds of Brac? 12 1 /31 /21 Adding or Dropping... resource 11 Product-Mix Decisions – Example – P11-42 WechslerCompanyproducesthreeproducts: A 130 ,B324,and C587 All three products use the same direct material, Brac Unit data for the three products... have on the company’s operating income? 14 1 /31 /21 Customer Profitability Analysis- Illustrated 15 Customer Profitability Analysis- Illustrated 16 1 /31 /21 Sometimes difficult due to amount of information