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
