ACCT 201 - Chapter 6 Notes

A manager’s most important responsibility

Making decisions.

Managerial decisions examples

Deciding what products to sell, whether to make or buy component parts, what prices to charge, what channels of distribution to use, and whether to accept special orders at special prices.

Six key concepts in making intelligent decisions

Defining the alternatives, distinguish between relevant and irrelevant costs and benefits, differential analysis-focusing on future costs and benefits that differ between the alternatives, sunk costs are always irrelevant when choosing among alternatives, future costs and benefits that do not differ between alternatives are irrelevant to the decision-making process, and opportunity costs also need to be considered when making decisions.

First step in making intelligent decisions

Defining the alternatives.

Every decision involves

Choosing from among at least two alternatives.

Second step in making intelligent decisions

Need to distinguish between relevant and irrelevant costs and benefits.

Relevant cost

A cost that should be considered when making decisions.

Relevant benefit

A benefit that should be considered when making decisions.

Irrelevant cost

A cost that should be ignored when making decisions.

Irrelevant benefit

A benefit that should be ignored when making decisions.

Distinguishing between relevant and irrelevant costs and benefits are an important concept for two reasons

Ignoring irrelevant data saves decision-makers tremendous amounts of time and effort. Erroneously including irrelevant costs and benefits when analyzing alternatives can lead to bad decisions.

Differential analysis

Focusing on future costs and benefits that differ between the alternatives. Everything else is irrelevant and should be ignored.

Third concept in making intelligent decisions

Differential analysis.

Differential cost

A future cost that differs between any two alternatives. Always relevant costs.

Differential revenue

Future revenue that differs between any two alternatives. Example of a relevant benefit.

Incremental cost

An increase in cost between two alternatives.

Incremental cost example

Choosing between buying the standard model or deluxe model of your favorite automobile, the costs of the upgrades.

Avoidable cost

A cost that can be eliminated by choosing one alternative over another in a decision. This term is synonymous with differential cost and relevant cost.

Avoidable cost example

You have decided to watch a movie tonight; however, you are trying to choose between two alternatives—going to the movie theater or renting a movie. The cost of the movie ticket is an ___. You would avoid this cost by renting a movie. Movie rental fee is an ___ because you could avoid it by going to the movie theater.

Fourth concept in making intelligent decisions

Sunk costs are always irrelevant when choosing among alternatives.

Sunk cost

A cost already incurred that cannot be changed by any decision made now or in the future.

Sunk cost example

A company purchased a five-year-old truck for $12,000. The amount paid for the truck is a ___ because it has already been incurred and the transaction cannot be undone. The amount paid is irrelevant in making decisions such as selling or replacing the truck.

Fifth concept in making intelligent decisions

Future costs and benefits that do not differ between alternatives are irrelevant to the decision-making process.

Do not differ between alternatives

Future costs and benefits that ____ are irrelevant to the decision-makking process.

Sixth concept in making intelligent decisions

Opportunity costs also need to be considered when making decisions.

Opportunity cost

The potential benefit given up when one alternative is selected over another.

Opportunity cost example

If you gave up a high-paying summer job to travel overseas, the forgone wages would be an ___ of traveling abroad.

Isolating relevant costs is desirable for at least two reasons

Rarely will enough information be available to prepare an income statement for both alternatives. Commingling irrelevant and relevant costs creates a risk that an irrelevant piece of data may be used improperly, resulting in an incorrect decision.

Avoidable expenses

Salaries expense, advertising expense, and insurance expense.

Unavoidable expenses

Utilities expense, depreciation expense, rent expense, and general administrative expense.

Vertical integration

The involvement by a company in more than one of the activities in the entire value chain from development through production, distribution, sales, and after-sales service.

Sourcing decision

A decision concerning whether a product or service should be produced or provided internally or purchased from an outside vendor.

Vertical integration advantages

A company is less dependent on its suppliers and may be able to ensure a smoother flow of parts and materials for production than a nonintegrated company. Some companies feel they can control quality better by producing their own parts rather than relying on the quality control standards of outside suppliers. An integrated company realizes profits from the parts it “makes” rather than “buys.”

Special order

A one-time order not considered part of the company’s normal ongoing business.

A special order should be accepted

The incremental revenue exceeds its incremental cost. However, it’s important to make sure there is idle capacity and it doesn’t reduce normal unit sales or undercut prices on normal sales.

Volume trade-off decisions

Companies must trade off or sacrifice production of some products in favor of others in an effort to maximize profits.

Forced to make volume trade-off decisions

Companies are ____ when they do not have enough capacity to produce all the products and sales volumes demanded by their customers.

Constraint

A limitation under which a company must operate, such as limited available machine time or raw materials, that restricts the company’s ability to satisfy demand. Anything preventing you from getting more of what you want.

Bottleneck

A machine or some other part of a process that limits the total output of the entire system.

Procedure to follow to strengthen the chain

Identify the weakest link, which is the constraint. Do not place a greater strain on the system than the weakest link can handle—if you do, the chain will break. Concentrate improvement efforts on strengthening the weakest link. If the improvement efforts are successful, eventually the weakest link will improve to the point where it is no longer the weakest link.

When a constraint existhrees

Managers can increase profits by making the products with the highest contribution margin per unit of the constrained resources.

Relaxing (or elevating) the constraint

An action that increases the amount of a constrained resource. Equivalently, an action that increases the capacity of the bottleneck.

Joint products

Two or more products produced from a common input.

Split-off point

That point in the manufacturing process where some or all of the joint products can be recognized as individual products.

Sell or process further decision

A decision as to whether a joint product should be sold at the split-off point or sold after further processing.

Joint costs

Costs incurred up to the split-off point in a process that produces joint products.

Three-step process managers use for sell or process further decision-making

They ignore all joint costs incurred up to the split-off point. They calculate the incremental revenue earned by further processing the joint product. They take the incremental revenue from step two and subtract the incremental costs associated with processing the joint product beyond the split-off point.

Using the differential approach is desirable for two reasons

Only rarely will enough information be available to prepare detailed income statements for both alternatives. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical.

One of the most important decisions managers make

Whether to add or drop a business segment.

Financial impact

A decision to drop an old segment or add a new one is going to hinge primarily on its ___.

Vertical integration disadvantages

Companies may fail to take advantage of supplies who can create economies of scale advantage by pooling demand from numerous companies. While the economics of scale factor can be appealing, a company must be careful to retain control over activities that are essential to maintaining its competitive position.

Opportunity costs are not

Actual cash outlays. Recorded in the formal accounts of an organization.

When analyzing a special order

Only incremental costs and benefits are relevant.

A typical approach

To allocate joint costs according to the relative sales value of the end products.

It is profitable to continue processing a joint product after the split-off point so long as

Incremental revenue from such processing exceeds the incremental processing costs incurred after the split-off point.

Differential profit equals

Incremental revenue minus incremental costs.

Cost to make equals

Total relevant costs of making.

Cost to buy equals

Purchase price + Other relevant costs.

Incremental profit equals

Incremental revenue minus incremental costs.