Chapter 122024

Horngren’s Cost Accounting: A Managerial
Emphasis
Seventeenth Edition
Chapter 12
Decision-Making and
Relevant Information
Learning Objectives (1 of 2)
1 Use the five-step decision-making process
2 Distinguish relevant from irrelevant information in decision
situations
3 Explain the concept of opportunity cost and why managers
should consider it when making insourcing versus outsourcing
decisions
4 Know how to choose which products to produce when there
are capacity constraints
5 Explain how to manage bottlenecks
Copyright © 2021, 2018, 2016 Pearson Education, Inc. All Rights Reserved
Learning Objectives (2 of 2)
6 Discuss the factors managers must consider when adding
or dropping customers or business units
7 Explain why book value of equipment is irrelevant to
managers making equipment-replacement decisions
8 Explain how conflicts can arise between the decision
model a manager uses and the performance-evaluation
model top management uses to evaluate managers
Information and the Decision Process
Managers usually follow a decision model for choosing
among different courses of action.
• A decision model is a formal method of making a choice
that often involves both quantitative and qualitative
analyses.
• Management accountants analyze and present relevant
data to guide managers’ decisions.
• Managers use the five-step decision-making process
presented in Chapter 1 to make decisions.
Five-Step Decision-Making Process
Exhibit 12.1 Five-Step Decision-Making Process for Precision Sporting Goods
The Concept of Relevance
• Relevant information has two characteristics:
– It occurs in the future.
– It differs among the alternative courses of action.
• Relevant costs are expected future costs.
• Relevant revenues are expected future revenues.
• Past costs (historical costs) are never relevant and are
also called sunk costs.
Qualitative and Quantitative Relevant
Information
Managers divide the outcomes of decisions into two broad
categories: quantitative and qualitative.
• Quantitative factors are outcomes that are measured in
numerical terms.
• Qualitative factors are outcomes that are difficult to
measure accurately in numerical terms, such as
satisfaction.
Although quantitative nonfinancial factors and qualitative
factors are difficult to measure in financial terms, they are
important for managers to consider.
Relevant Cost Illustration
Exhibit 12.2 Determining Relevant Revenues and Relevant Costs
Sunk Costs Are Irrelevant in
Decision-Making
• Sunk costs are costs that have already occurred and
cannot be changed.
• Sunk costs are excluded because they cannot be changed
by future actions.
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
Now, let’s look at the types of decisions that need to be
made.
Types of Decisions That Need to Be
Made (1 of 4)
• One-time-only special orders (Slide 15)
• Short-run pricing decisions (Slide 19)
• Insourcing v s outsourcing (make or buy) (Slide 20)
ersu
– Outsourcing and idle facilities (Slide 21)

– Strategic and qualitative factors (Slide 21)
– International outsourcing (Slide 22)
– The total alternatives approach (Slide 22)
– The opportunity-cost approach (Slide 23)
– Carrying costs of inventory (Slide 23)
Made (2 of 4)
• Product-mix decisions with capacity constraints (Slide 24)
– Managers make decisions about which products to sell
and in what quantities. These decisions usually have
only a short-run focus because they typically arise in
the context of capacity constraints that can be relaxed
in the long run.
Made (3 of 4)
• Bottlenecks, theory of constraints, and throughput-margin
analysis (Slide 26)
– The theory of constraints (TOC) describes methods to
maximize operating income when faced with some
bottleneck and some bottleneck operations. To
implement TOC, we define and use three measures:
§ Throughput margin
§ Investment equals the sum of materials, R&D costs
and capital costs of equipment and buildings
§ Operating costs equal costs of operations (other
than direct materials)
Made (4 of 4)
• Customer profitability and relevant costs (Slide 29)
– Managers must make decisions about adding or
dropping a product line or business segment, but if the
cost object is a customer, managers must decide about
adding (Slide 32) or dropping customers (Slide 31).
• Branch/segment: adding or discontinuing (Slide 31)
• Equipment replacement (Past costs are irrelevant) (Slide
34)
One-Time-Only Special Orders
• Decision: To accept or reject special orders when there is
idle production capacity and the special orders have no
long-run implications.
• Decision rule: Does the special order generate additional
operating income?
– Yes—accept
– No—reject
• Compares relevant revenues and relevant costs to
determine profitability.
Special Orders Decisions
Exhibit 12.5 Comparative Contribution Income Statements
Potential Problems in Relevant-Cost
Analysis
• Managers should avoid two potential problems in
relevant–cost analysis:
1. Avoid incorrect general assumptions such as “All
variable costs are relevant, and all fixed costs are
irrelevant.” Even in our simple example, we had
irrelevant, variable marketing costs.
2. Be aware that unit-fixed-cost data can potentially
mislead managers in two ways.
(See next slide for details)
Beware: Unit-Fixed-Cost Data
Unit-fixed-cost data can potentially mislead managers in two
ways:
• Fixed unit costs might include irrelevant costs, costs that
will not change whether or not the one-time only order is
accepted or not.
• If using the same unit fixed costs at different output levels,
managers may reach erroneous conclusions. Total fixed
costs should be used.
Short-Run Pricing Decisions
• A special order decision is, in many respects, a short-run
pricing decision.
• Sometimes, the decision is simply about setting an
acceptable price.
• Remember the decision rule?
• Any price above incremental costs will improve operating
income; however, consideration must be given to capacity
constraints, current market conditions, customer demand,
competition, etc.
Insourcing Versus Outsourcing and
Make-or-Buy Decisions (1 of 4)
• Outsourcing is purchasing goods and services from
outside vendors.
• Insourcing means you’ll produce the good (or provide the
service) within the organization.
• Decisions about whether to insource or outsource are
called make-or-buy decisions.
• Opportunity costs are the contribution to operating
income forgone by not using a limited resource in its next-
best alternative use.
Outsourcing and Idle Facilities
• To make a good decision, managers must consider the
difference in relevant costs between the alternatives,
including the cost of idle capacity and related fixed costs.
Strategic and Qualitative Factors
• Outsourcing decisions invariably have a long-run horizon
in which the financial costs and benefits of outsourcing
become more uncertain. Almost always, strategic and
qualitative factors become important determinants of the
outsourcing decision. Weighing all these factors requires
considerable managerial judgment and care.
International Outsourcing
• International outsourcing requires managers to evaluate
manufacturing and transportation costs, exchange-rate
risks, and other strategic and qualitative factors, such as
quality, reliability, and efficiency of the supply chain.
The Total Alternatives Approach
• This approach simply means that managers should
consider future costs and revenues for all products. If, for
example, one decision will create idle capacity but that idle
capacity can be used for manufacture of another product,
that should be considered in the overall decision.
The Opportunity-Cost Approach
• Opportunity cost is the contribution to operating income that is forgone
by not using a limited resource in its next-best alternative use.
Deciding to use a resource one way means a manager must forgo the
opportunity to use the resource in any other way. Managers must
consider that cost in their decision-making.
Carrying Costs of Inventory

• Recall that under the opportunity-cost approach, the relevant cost of
any alternative is (1) the incremental cost of the alternative plus (2) the
opportunity cost of the profit forgone from choosing that alternative.
The opportunity cost of holding inventory is the income forgone by
tying up money in inventory and not investing it elsewhere.
Product-Mix Decisions with Capacity
Constraints
Product-mix decisions are decisions managers make 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
(not the highest contribution margin per unit of the
product).
Product-Mix Decisions with Capacity
Constraint Example
Item Product A Product B

Selling price $10 $30
Variable cost per unit $6 $15
Contribution margin/unit $4 $15
Contribution margin % 40% 50%
Machine hours required per unit 0.5 3.0
Contribution margin/machine hour $8 $5
Bottlenecks, Theory of Constraints, and
Throughput-Margin Analysis (1 of 3)
A bottleneck is a phenomenon where the performance or
capacity of an entire system is limited by a single or limited
number of components or resources. The term bottleneck is
taken from the “assets are water” metaphor. As water is
poured out of a bottle, the rate of outflow is limited by the
width of the conduit of exit—that is, bottleneck. By increasing
the width of the bottleneck, one can increase the rate at
which the water flows out of the neck at different
frequencies. Such limiting components of a system are
sometimes referred to as bottleneck points.
The theory of constraints (T O C) describes methods to
maximize operating income when faced with some
bottleneck and some non-bottleneck operations. T O C
defines these three measures:
• Throughput margin
• Investments
• Operating costs
The objective of TOC is to increase throughput margin while
decreasing investments and operating costs. TOC focuses
on managing bottleneck operations.
Managing bottleneck operations has four steps:
1. Recognize that bottleneck operations determine the
contribution margin of the entire system.
2. Identify the bottleneck operations.
3. Keep the bottleneck operation busy and subordinate all
non-bottleneck operations to the bottleneck operation.
4. Take actions to increase the efficiency and capacity of the
bottleneck operation.
Customer Profitability and Relevant
Costs (1 of 2)
• When the cost object is a customer, managers must
decide about adding or dropping the customer.
• 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 incremental income of the customer,
not how much revenue a customer generates.
Customer Profitability and Relevant
Costs (2 of 2)
Exhibit 12.8 Customer Profitability Analysis
Blank
Customer Customer Customer Customer

Vogel Brenner Wisk Total
Revenues $500,000 $300,000 $400,000 $1,200,000
Cost of goods sold 370,000 220,000 330,000 920,000
Furniture-handling labor 41,000 18,000 33,000 92,000
Furniture-handling equipment cost written
off as depreciation 12,000 4,000 9,000 25,000
Rent 14,000 8,000 14,000 36,000
Marketing support 11,000 9,000 10,000 30,000
Sales order and delivery processing 13,000 7,000 12,000 32,000
General administration 20,000 12,000 16,000 48,000
Allocated corporate-office costs 10,000 6,000 8,000 24,000
Total costs 491,000 284,000 432,000 1,207,000
Operating income $ 9,000 $ 16,000 $ (32,000) $ (7,000)
Customer Profitability Analysis: Relevant-
Revenue and Relevant-Cost Analysis of
Dropping a Customer
When a customer doesn’t produce positive operating
income, managers should attempt to determine why. Some
possible reasons might be the following:
• Low-margin products ordered
• High sales order costs
• High delivery-processing and other handling costs
• High marketing costs
Once identified, managers could work with the customer to

reduce costs so the customer becomes profitable.
Customer Profitability Analysis: Relevant-
Revenue and Relevant-Cost Analysis of Adding
a Customer
• At least one critical distinction exists between the relevant
costs of adding versus dropping a customer.
• Depreciation cost is irrelevant in deciding whether to drop
a customer because depreciation on equipment that has
already been purchased is a past (sunk) cost, but the cost
of purchasing new equipment in the future that will then be
written off as depreciation is relevant in deciding whether to
add a customer.
Relevant-Revenue and Relevant-Cost Analysis
of Closing or Adding Branch Offices or
Business Divisions
Sometimes companies must decide about closing or adding
branch offices or business divisions.
This analysis is similar to the decision process of adding or
closing a customer, with a notable exception:
• Often, branches or divisions are allocated a share of
corporate-office costs. If a branch or division is closed,
these costs may be allocated differently but they may not
actually change.
Irrelevance of Past Costs and
Equipment-Replacement Decisions
Some items of cost are Not relevant:
• Cost, accumulated depreciation, and book value of existing
equipment
• Any potential gain or loss on the transaction, a financial
accounting phenomenon only
• Sunk costs (past costs) are unavoidable, cannot be
changed no matter what action is taken, and are not
relevant.
Some items of cost May Be relevant:
• Current disposal value of old machine and cost of new
machine
Decisions and Performance
Evaluation (1 of 2)
• Despite the quantitative nature of some aspects of
decision making, not all managers will choose the best
alternative for the firm.
• Managers will consider how the company will judge his or
her performance after the decision is implemented.
• Many managers consider it unethical to take actions that
make their own performance look good when these actions
are not in the best interests of the firm.
Decisions and Performance
Evaluation (2 of 2)
• The decision model analysis (step 4) can dictate one
decision, but in the real world, would the manager want to
follow it?
Managers frequently find it difficult to resolve the conflict
between the decision model and the performance-evaluation
model. In theory, resolving the difficulty seems obvious:
Managers should design models that are consistent.

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Horngren’s Cost Accounting: A Managerial

– Outsourcing and idle facilities (Slide 21)

Carrying Costs of Inventory

Item Product A Product B

Customer Customer Customer Customer

Once identified, managers could work with the customer to

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