Relevant Information and

Decision Making
Chapter 2
 Introduction

 This chapter explores the decision-making

process.
 It focuses on specific decisions such as
accepting or rejecting a one-time-only special
order, insourcing or outsourcing products or
services, and replacing or keeping equipment.
 Five-Step Decision Process

1 Gathering information
2 Making predictions
3 Choosing an alternative
4 Implementing the decision
5 Evaluating performance
 Quantitative and Qualitative
Relevant Information
 Quantitative factors are outcomes that are
measured in numerical terms:
– Financial
– Nonfinancial
 Qualitative factors are outcomes that cannot
be measured in numerical terms.
 One-Time-Only Special Order

 Gabriela & Co. manufactures fancy bath towels

in Boone, North Carolina.
 The plant has a production capacity of 44,000
towels each month.
 Current monthly production is 30,000 towels.
 The assumption is made that costs can be
classified as either variable with respect to units
of output or fixed.
One-Time-Only Special Order

Variable Fixed
Costs Costs
Per Unit Per Unit
Direct materials $6.50 $ -0-
Direct labor .50
1.50 Manufacturing costs 1.50 3.50
Total $8.50 $5.00
 One-Time-Only Special Order

 Total fixed direct manufacturing labor

amounts to $45,000.
 Total fixed overhead is $105,000.
 Marketing costs per unit are $7 ($5 of which
is variable).
 What is the full cost per towel?
 One-Time-Only Special Order

 Variable ($8.50 + $5.00): $13.50

 Fixed: 7.00
 Total $20.50
 A hotel in Puerto Rico has offered to buy
5,000 towels from Gabriela & Co. at $11.50
per towel for a total of $57,500.
 One-Time-Only Special Order

 No marketing costs will be incurred for this

one-time-only special order.
 Should Gabriela & Co. accept this order?
 Yes!
 Why?
 One-Time-Only Special Order

 The relevant costs of making the towels are

$42,500.
 $8.50 × 5,000 = $42,500 incremental costs
 $57,500 – $42,500 = $15,000 incremental
revenues
 $11.50 – $8.50 = $3.00 contribution margin
per towel
 One-Time-Only Special Order

 Decision criteria:
 Accept the order if the revenue differential
is greater than the cost differential.
 Insourcing versus Outsourcing

 Outsourcing is the process of purchasing

goods and services from outside vendors
rather than producing goods or providing
services within the organization, which is
called insourcing.
 Make-or-Buy Decisions

 Decisions about whether to outsource or

produce within the organization are often
called make-or-buy decisions.
 The most important factors in the make-or-buy
decision are quality, dependability of supplies,
and costs.
 Make-or-Buy Decisions

 Gabriela & Co. also manufactures bath

accessories.
 Management is considering producing a
part it needs (#2) or using a part produced
by Alec Enterprises.
 Make-or-Buy Decisions

 Gabriela & Co. has the following costs for

150,000 units of Part #2:
 Direct materials $ 28,000 Direct
labor 18,500 Mixed
overhead 29,000 Variable
overhead 15,000 Fixed
overhead 30,000 Total
$120,500
 Make-or-Buy Decisions

 Mixed overhead consists of material handling

and setup costs.
 Gabriela & Co. produces the 150,000 units in
100 batches of 1,500 units each.
 Total material handling and setup costs equal
fixed costs of $9,000 plus variable costs of
$200 per batch.
 Make-or-Buy Decisions

 What is the cost per unit for Part #2?

 $120,500 ÷ 150,000 units = $0.8033/unit
 Alec Enterprises offers to sell the same part
for $0.55.
 Should Gabriela & Co. manufacture the part
or buy it from Alec Enterprises?
 Make-or-Buy Decisions

 The answer depends on the difference in

expected future costs between the alternatives.
 Gabriela & Co. anticipates that next year the
150,000 units of Part #2 expected to be sold
will be manufactured in 150 batches of 1,000
units each.
 Make-or-Buy Decisions

 Variable costs per batch are expected to

decrease to $100.
 Gabriela & Co. plans to continue to produce
150,000 next year at the same variable
manufacturing costs per unit as this year.
 Fixed costs are expected to remain the same
as this year.
 Make-or-Buy Decisions

 What is the variable manufacturing cost

per unit?
 Direct material $28,000 Direct
labor 18,500 Variable
overhead 15,000 Total
$61,500
 $61,500 ÷ 150,000 = $0.41 per unit
 Make-or-Buy Decisions

 Expected relevant cost to make Part #2:

 Manufacturing $61,500
Material handling and setups 15,000*
Total relevant cost to make $76,500 *150
× $100 = $15,000
 Cost to buy: (150,000 × $0.55) $82,500
 Gabriela & Co. will save $6,000 by making the
part.
 Make-or-Buy Decisions

 Now assume that the $9,000 in fixed clerical

salaries to support material handling and setup
will not be incurred if Part #2 is purchased
from Alec Enterprises.
 Should Gabriela & Co. buy the part or make
the part?
 Make-or-Buy Decisions

 Relevant cost to make:

 Variable $76,500
Fixed 9,000
Total $85,500
 Cost to buy: $82,500
 Gabriela would save $3,000 by buying
the part.
 Product-Mix Decisions Under
Capacity Constraints
 What product should be emphasized to
maximize operating income in the face of
capacity constraints?
 Gabriela & Co. produces Product #2 and
Product #3.
 The company has 3,000 machine hours
available to produce these products.
 Product-Mix Decisions Under
Capacity Constraints
 Decision criteria:
Aim for the highest contribution margin per
unit of the constraining factor.
 When multiple constraints exist, optimization
techniques such as linear programming can be
used in making decisions.
 Product-Mix Decisions Under
Capacity Constraints
 Per unit Product #2 Product #3
Sales price $2.11 $14.50
Variable expenses 0.41 13.90
Contribution margin $1.70 $ 0.60
 Contribution margin ratio 81% 4%
 Product-Mix Decisions Under
Capacity Constraints
 One unit of Prod. #2 requires 7 machine hours.
 One unit of Prod. #3 requires 2 machine hours.
 What is the contribution of each product per
machine hour?
 Product #2: $1.70 ÷ 7 = $0.24
 Product #3: $0.60 ÷ 2 = $0.30
 Product-Mix Decisions Under
Capacity Constraints
 Which product should be emphasized?
 The product with the highest contribution
margin per unit of the constraining resource.
 Equipment-Replacement
Decisions
 Assume that Gabriela & Co. is considering
replacing a cutting machine with a newer
model.
 The new machine is more efficient than the
old machine.
 Revenues will be unaffected.
 Equipment-Replacement
Decisions
Existing Replacement
Machine Machine
Original cost $80,000 $105,000
Useful life 4 years 4 years
Accumulated depreciation $50,000
Book value $30,000
Disposal price $14,000
Annual costs $46,000
$ 10,000
 Equipment-Replacement
Decisions
 Ignoring the time value of money and income
taxes, should Gabriela replace the existing
machine?
 Yes!
 The cost savings per year are $36,000.
 The cost savings over a 4-year period will be
$36,000 × 4 = $144,000.
 Equipment-Replacement
Decisions
 Investment = $105,000 – $14,000 = $91,000
 $144,000 – $91,000 = $53,000 advantage of
the replacement machine.
End of Chapter 2