Chapter 23: Summary Cheat Sheet

Key Points on Decisions and Relevant Information Understanding relevant information for decision-making is crucial, particularly in distinguishing between costs that affect future decisions and those that do not. Below are some essential cost concepts that guide managerial decisions: Relevant Costs and Revenues • • • • • • Incremental Revenue: Additional revenue from a specific decision. Relevant. Incremental Cost: Additional costs incurred because of a decision. Relevant. Incremental Income: The difference in income between alternatives. Relevant. Sunk Cost: Costs already incurred and cannot be changed. Not Relevant. Out-of-Pocket Cost: Future cash outlays due to a decision. Relevant. Opportunity Cost: The benefit lost from choosing one option over another. Relevant. Decision Rules for Common Scenarios Production Decisions 1. Make or Buy: o Choose the option with the lower total cost. 2. Sell or Process: o Process further if doing so results in higher overall income. 3. Scrap or Rework: o Choose the alternative with the highest increase in income. 4. Sales Mix: o Unlimited Demand: Focus production on the product with the highest contribution margin per unit of a scarce resource. o Limited Demand: Allocate production to the product with the highest contribution margin per unit of scarce resource up to its demand, then shift to the next best option. Capacity Decisions 5. Segment Elimination: o Eliminate a segment if overall income increases without it. 6. Keep or Replace: o Replace an asset if it results in an increase in total income. Pricing Decisions 7. Normal Pricing: Ensure the price covers all costs plus a target profit. o Total Cost Pricing: Includes all costs with a markup to set the price. o Target Cost Pricing: Adjust production to meet target costs to maintain profitability. o Variable Cost Pricing: Focuses on variable costs plus markup. 8. Special Offer Pricing: o Accept a special offer if it increases net income (incremental income is positive). 9. Time and Materials Pricing: o Includes direct labor costs (with overhead and profit) and a materials markup percentage. o Multiple Choice Quiz Overview 1. Sunk Cost: o Definition: A past cost that cannot be changed. o Answer: (c) A sunk cost. 2. Opportunity Cost: o Definition: The potential benefit lost when choosing one alternative over another. o Answer: (d) An opportunity cost. 3. Defective Music Players Decision: o Analysis: Selling defective players for $8 or reworking them for $10 to sell at $19. o Decision: Rework the players, yielding a $1 net gain per unit ($19 $18 for rework). 4. Productive Capacity Utilization: o Product X requires 10 machine hours, Product Y requires 2 machine hours. o Contribution Margin Analysis:  Product X: $2 per machine hour.  Product Y: $7 per machine hour. o Decision: Produce only Product Y for the highest contribution margin per machine hour. 5. Special One-Time Order: o Given a special order for 3,000 units at $15 each, with additional fixed costs. o Decision: Accept the order, as it increases income by $13,000. Analysis and Answers for the Quiz 1. Sunk Cost (Question 1): Answer is (c). 2. Opportunity Cost (Question 2): Answer is (d). 3. Defective Music Players (Question 3): o Reworking provides a $1 net profit per unit. Answer is (a): Rework the players. 4. Productive Capacity Utilization (Question 4): o Highest contribution margin per machine hour favors Product Y. o Answer is (e): Produce only Product Y. 5. Special Order (Question 5): o Revenue ($45,000) exceeds total costs ($32,000) by $13,000. o Answer is (a): Yes, revenue exceeds costs. o Conclusion Effective decision-making in business relies on understanding relevant information and applying the correct evaluation criteria. Properly distinguishing between relevant costs (incremental, out-of-pocket, opportunity) and irrelevant ones (like sunk costs) guides managers toward financially sound choices. Each scenario demands specific analysis methods to ensure choices align with business profitability and efficiency goals.