Cost Accounting

Cost Accounting

Historical Other Costs Information Feedback Step 2: Making Predictions use the information from step 1 together with an assessment f probability as a basis for predicting the future labor costs of $640,000 and $480,000 respectively for the “do not arrange” and “rearrange” alternatives. The rearrangement is predicted to cost $90,000. Specific Step 3: Choosing an Alternative step 4: Implementing the Decision step 5: Evaluating Performance The predicted benefits of the different alternatives in step 2 are compared and are related to the size of the required investment along with other considerations (such as likely effects on employee morale).

Management chooses the “rearrange” alternative. The manager implements the decision reached in step 3 by rearranging the manufacturing assembly line. Evaluation of performance of the decision implemented in step 4 provides the feedback as the five-step sequence is then repeated in whole or in part. New manufacturing labor costs are $550,000 rather than the predicted $480,000. This historical information can help managers in making subsequent predictions, or improving implementation through, for example, employee training.

The Meaning Of Relevance Relevant Costs and Relevant Revenues OBJECTIVE 2 Distinguish relevant costs and revenues from irrelevant costs and revenues in any decision situation Relevant costs. Expected future sots that differ across alternative courses of action. Relevant revenues. Expected future revenues that differ across alternative courses of action. 422 CHAPTER 11 The most important decision-making concepts in this chapter are relevant costs and relevant revenues.

Relevant costs are those expected future costs that differ between alternative COUrses Of action. The two key aspects to this definition are that the costs must occur in the future and that they must differ between the alternative courses of action. We focus on the future because every decision deals with the future-?whether it be 20 seconds ahead (the session to adjust a dial) or 20 years ahead (the decision to plant and harvest pine trees). The function of decision making is to select courses of action intended to improve future outcomes.

Nothing can be done to alter the past. Future costs must differ among the alternatives. If they do not, irrespective of the decision, there will be no difference in costs and therefore no future improvement in cost outcomes. Likewise, relevant revenues are those expected future revenues that differ between alternative courses of action. In Exhibit 1 1-2, the $640,000 and $480,000 manufacturing labor costs are elevate costs-?they are expected future costs that differ between the two alternatives.

The past manufacturing labor rate of $14 per hour and total past manufacturing labor costs of $560,000 (2,000 hours C] 20 workers C] $14 per hour) are not relevant, even though they may play a role in preparing the $640,000 and $480,000 labor cost predictions. Although they may be a useful basis for making informed judgments for predicting expected future costs, historical costs in themselves are irrelevant to a decision. Why? Because they deal strictly with the past, not the future, and cannot be changed. EXHIBIT 11-2

Determining Relevant Revenues and Relevant Costs for Precision Sporting Goods All Revenues and Costs Relevant Revenues and Costs Alternative 1: Do Not Reorganize Alternative 2: Reorganize 640,chic 750,000 $1 0,oho 480,Dodd 90,000 $ 640,coo 640,000 $ 480,Dodd 570,000 Revenues Costs: Direct materials Manufacturing labor Manufacturing overhead Marketing Reorganization costs Total costs Operating income AAA,oho bib,oho units x $250 per unit = units x $50 per unit = CA did $70,000 Difference workers x 2,000 hours per worker x $16 per hour = $640,000 workers x 2,000 hours per worker x $16 per hour = $480,000

Exhibit 1 1-2 presents the quantitative data underlying the choice between the “do not rearrange” and the “rearrange” alternatives. The first two columns present all data. The last two columns present only relevant costs or revenues. The revenues, direct materials, manufacturing overhead, and marketing items can be ignored. Why? Because although they are expected future costs, they do not differ among the alternatives. They are thus irrelevant. The data in Exhibit 1 1-2 indicate that rearranging the production line will increase next year’s predicted operating income by $70,000.

Note hat we reach the same conclusion whether we use all data or include only the relevant data in the analysis. By confining the analysis to only the relevant data, managers can clear away related but irrelevant data that might confuse them. The difference in total cost between two alternatives is a differential or net relevant cost. The differential cost between alternatives 1 and 2 in Exhibit 11-2 is $70,000. Managers may prefer to focus only on relevant revenues and relevant costs (the last two columns in Exhibit 1 1-2) because in doing so they reduce their information load by excluding irrelevant ATA.

Too much information decreases rather than increases the quality of a managers decisions as well as increases the time it takes to make decisions. Differential cost (net relevant cost). Difference in total cost between two alternatives. Quantitative and Qualitative Relevant Information We divide the consequences of alternatives into two broad categories: quantitative and qualitative. Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors are financial-?that is, they can be easily expressed in financial terms.

Examples include the costs f direct materials, direct manufacturing labor, and marketing. Other quantitative factors are nonofficial-?that is, they can be measured numerically, but they are not expressed in financial terms. Reduction in product development time for a manufacturing company and the percentage of on-time flight arrivals for an airline company are examples of quantitative, nonofficial factors. Qualitative factors are outcomes that cannot be measured in numerical terms. Employee morale is an example.

Cost analysis generally emphasizes quantitative factors that can be expressed in financial terms. Despite the difficulty and sometimes the impossibility of measuring qualitative and nonofficial quantitative factors in financial terms, these factors remain important. Managers must at times give more weight to either qualitative or nonofficial quantitative factors than to financial factors. For example, precision Sporting Goods may find that it can purchase a part from an outside supplier at a understand the difference between quantitative factors and qualitative factors in decisions 3 Quantitative factors.

Outcomes that are measured in numerical terms. Qualitative factors. Outcomes that cannot be measured in numerical terms. DECISION MAKING AND RELEVANT INFORMATION 423 price that is lower than what it costs to manufacture the part in-house. The company may still choose to make the part in-house because it feels that the supplier is unlikely to meet the demanding delivery schedule-?a quantitative nonofficial factor-?and because purchasing the part from outside may adversely affect employee morale-?a qualitative factor.

Trading off nonofficial and financial considerations is seldom easy. An Illustration Of Relevance: Choosing Output Levels Managers often make decisions that affect output levels. For example, managers must choose whether to introduce a new product or sell more units of an existing product. When changes in output levels occur, managers are interested in the effect they have on the organization and on operating income. Why? Because maximizing organizational objectives (typically, operating income in our illustrations) also increases managers’ rewards.

One-Time-Only Special Orders 424 Management sometimes faces the decision of accepting or rejecting one- time-only special orders when there is idle production capacity and when the order has no long-run implications. We assume that all costs can be classified as either variable with respect to a single driver (units of output) or fixed. The following example illustrates how focusing on revenues, variable costs, and contribution margins can provide key information for decisions about the choice of output level.

The example also indicates how reliance on unit-cost numbers calculated after allocating fixed costs can mislead managers about the effect that increasing output has on operating income. Example 1: Surf Gear manufactures quality beach towels at its highly automated plant. The plant has a production capacity of 48,000 towels each month. Current monthly production is 30,000 towels. Retail department stores account for all existing sales. Expected results for the coming month (August) are shown in Exhibit 11-3. These amounts are predictions based on past costs. ) We assume all costs can be classified as either fixed or variable with respect to a single cost driver (units of output). Exhibit 1 1-3 presents data in an absorption costing format: In this exhibit, the manufacturing cost of $12 per unit and the marketing cost of $7 per unit include both variable and fixed costs. The sum of all costs (variable and fixed) in a particular business function of the value chain, such as manufacturing costs or marketing costs, are called business function costs.

Full product costs, in this case SSL 9 per unit, are the sum of all variable and fixed costs in all business functions of the value chain (R&D, design, production, marketing, distribution, and customer service). For Surf Gear, full costs of the product consist of costs in manufacturing and marketing because these are the only business functions. As a result of a strike at its existing towel supplier, a luxury hotel chain has offered to buy 5,000 towels from Surf Gear in August at $1 1 per towel. No subsequent sales to this hotel chain are anticipated.

Axed manufacturing costs are tied to the 48,000-towel production capacity. That is, fixed manufacturing costs relate to the production capacity available, regardless of the capacity used. If Surf Gear accepts the special order, it will use existing idle capacity to produce the 5,000 towels, and fixed manufacturing costs will not change. No marketing costs will be necessary for the 5,000-unit one-time- only special order. Accepting this special order is not expected to affect the ailing price or the quantity of towels sold to regular customers.

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