Chapter 8: Using Accounting Information to Make Managerial Decisions
8 / Using Accounting Information to Make Managerial DecisionsUnit Summaries
Unit 8.1 – Identifying Relevant Information
This unit identifies the two characteristics of relevant information for decision making: (1) it differs between alternatives under consideration; and (2) the differences occur in the future. A relevant cost decision model is presented as a framework for the decisions that will be studied in the remaining units.
Unit 8.2 – Special Order Pricing
After discussing the characteristics of special orders, this unit illustrates the identification of relevant costs for special order pricing decisions. Qualitative issues that might influence the decision to accept a special order price are also discussed.
Unit 8.3 – Outsourcing
This unit presents definitions of outsourcing and offshoring and discusses the difference between the two practices. A basic outsourcing decision model is presented, including the consideration of opportunity costs from alternative use of any freed-up capacity. Qualitative issues that might influence the outsourcing decision are also discussed.
Unit 8.4 – Allocating Constrained Resources
Students are introduced to the concept of limited resources and how those limitations may impact production. Using the contribution margin per constrained resource, the unit presents a decision model for allocation of constrained resources that will maximize operating income. A brief introduction to the theory of constraints is included.
Unit 8.5 – Keeping or Eliminating Operations
This unit explains the concept of common costs that are not directly traceable to an operating segment and introduces segment margin analysis as a tool for evaluating the profitability of an operating segment. The segment margin income statement is presented as a tool for assisting managers as they evaluate whether to keep or eliminate a segment.
Running Case Recap
C&C Sports’ managers continue to look for ways to improve the company’s bottom line. They prepared a budget and evaluated performance against that budget. As a result, the company implemented activity-based costing in an effort to better understand the costs of producing the company’s three products. Now the company is evaluating short-term decision alternatives to assess their impact on the company’s profits.
Motivating the Chapter with The Pitch
At the weekly management team meeting, C&C Sports’ managers present three opportunities that may impact the company’s profitability. Bonadeo Embroidery has offered to provide the chenille letters used on award jackets. Bradley Textile Mills has informed the company of a potential fabric shortage. There is some concern that not all sales territories are profitable and that one or more may need to be eliminated. The chapter presents decision models for evaluating the profit impact of each of these decisions.
Assignment Classification by Learning Objective
Learning Objective / Exercises / Problems / Cases- Identify relevant information for decision making. (Unit 8.1)
- Determine the qualitative and quantitative impacts of special order pricing. (Unit 8.2)
- Determine the qualitative and quantitative impacts of outsourcing decisions. (Unit 8.3)
- Determine how to allocate constrained resources to maximize income. (Unit 8.4)
- Calculate the effects on operating income of keeping or eliminating operations. (Unit 8.5)
Assignment Characteristics
Number / Description / Learning Objectives / Bloom Levelsa / CMA Adapted / Difficulty Level / Estimated Time (min.)E8-1 / Identify relevant information / 1
E8-2 / Identify decision alternatives and relevant information / 1
E8-3 / Identify relevant information / 1
E8-4 / Calculate minimum special order price / 2
E8-5 / Calculate income effects from a special order / 2
E8-6 / Calculate income effects from a special order / 2
E8-7 / Calculate income effects from a special order / 2
E8-8 / Evaluate an outsourcing proposal / 3
E8-9 / Evaluate an outsourcing proposal and identify qualitative issues / 3
E8-10 / Evaluate an outsourcing proposal / 3
E8-11 / Evaluate an outsourcing proposal / 3
E8-12 / Allocate scarce production resources / 4
E8-13 / Allocate scarce production resources / 4
E8-14 / Allocate scarce production resources / 4
E8-15 / Identify desired information for evaluating segment performance / 5
P8-16 / Decide whether to eliminate a segment / 5
P8-17 / Prepare a segment margin income statement, evaluate income effect of eliminating a segment / 5
P8-18 / Calculate income effects from a special order / 2
aK=knowledge, C=comprehension, AP = application, AN=analysis S=synthesis, E=evaluation
Number / Description / Learning Objectives / Bloom Levelsa / CMA Adapted / Difficulty Level / Estimated Time (min.)P8-19 / Identify relevant information for an outsourcing proposal, calculate income effects from the outsourcing decision / 1, 3 /
P8-20 / Evaluate an outsourcing proposal / 3
P8-21 / Evaluate an outsourcing proposal, including opportunity costs related to freed up capacity / 3
P8-22 / Evaluate an outsourcing proposal with special pricing / 2, 3
P8-23 / Allocate scarce resources in a service setting / 4
P8-24 / Allocate scarce production resources and outsourcing alternatives / 3, 4
P8-25 / Decide whether to eliminate a segment / 5
P8-26 / Decide whether to eliminate a segment / 5 /
C8-27 / Identify relevant costs and evaluate alternatives / 1
C8-28 / Decide whether to eliminate a segment, evaluate an outsourcing proposal, evaluate a special order / 2, 3, 5
C8-29 / Identify and evaluate ethical issues in an outsourcing proposal / 3
aK=knowledge, C=comprehension, AP = application, AN=analysis S=synthesis, E=evaluation
Chapter Summary
Unit 8.1
LO 1Identify relevant information for decision making.
Relevant information satisfies two criteria: (1) it differs between alternatives, and (2) the difference will occur in the future.
Unit 8.2
LO 2Determine the qualitative and quantitative impacts of special order pricing.
Special orders arise because a customer wants a pricing arrangement that differs from the normal price. The justification for the price difference could be that the requested product differs from the normal product, that the customers buying in large quantities for which no regular volume discount is available, or that the customer is new and willing to try the product or service only at a special rate. Special orders can be advantageous to the company if excess capacity is available, or if the new business they generate is expected to have a long-term payoff.
To calculate the effect of a special order on operating income, first identify the avoidable costs associated with the special order. If capacity is available, then fixed overhead is an unavoidable cost. Watch out for the loss of normal sales if the entire special order can’t be filled with available capacity. In that case, lost contribution margin from normal sales is one cost of the special order.
If a company continually accepts special orders to fill capacity, then the larger issue to evaluate is whether a permanent use can be found for the capacity, or if not, whether some assets can be eliminated to reduce capacity costs.
Unit 8.3
LO 3Determine the qualitative and quantitative impacts of outsourcing decisions.
Outsourcing means moving the production of goods or the delivery of services from within the organization to a provider outside the organization. Quantitatively, outsourcing an operation will free up the resources it uses. However, it is critical that unavoidable costs be identified. Because those costs will continue with or without the outsourcing arrangement, they should not be included in the costs projected to be saved by outsourcing. Qualitatively, outsourcing can provide expertise the company doesn’t have, transfer risk to an outside supplier, and allow the company to focus on its core competencies. Potential dangers of outsourcing include poor quality, poor delivery times, and intellectual theft.
Unit 8.4
LO 4Determine how to allocate constrained resources to maximize income.
When company resources are limited in the amount of output they can generate, the best use of these resources is to make the product that generates the highest contribution per constrained resource. Do not, however, produce more product than the quantity customers demand.
Unit 8.5
LO 5Calculate the effects on operating income of keeping or eliminating operations.
The decision of whether to keep or eliminate an operation should be based on the operation’s segment margin. Common fixed costs should not be included in the operation’s income. If the segment margin is positive, the operation should be kept until a better use can be found for its resources. If the segment margin is negative, the operation should be dropped. Watch out for related sales or operations that might be affected by the operation under evaluation.
Related Reading
The Outsourcing Institute,
EquaTerra,
Outsourcing Center,
These three websites offer a variety of outsourcing and offshoring papers, reports, and news.
Carolyn Beeler, “Outsource Call Centers Return, To U.S. Homes,” All Things Considered, NPR, August 25, 2010.
This story (with audio) discusses how previously offshored call centers are returning to the U.S. A graph presents some interesting comparisons of effectiveness between foreign and U.S.-based call centers.
Dexter Roberts and Bob Chen, “As Wages Climb in China, Factories Move,”Bloomberg Businessweek, May 17 – May 23, 2010, 11-12 (available online at
PeteEngardio, “China’s Eroding Advantage,” BusinessWeek, June 15, 2009, 54-55. Available online at
These articles discuss how changes in the economics of outsourcing in China are making other outsource locations such as Mexico, or even domestic production, more attractive.
Additional Cases
Charles E. Davis and Elizabeth B. Davis, “Garden Patch Foods: Analyzing the Purchasing-through-Payables Process,” Issues in Accounting Education, November 2003, 369-383.
After significant expansion through acquisitions, Garden Patch Foods faces a decision about the future direction of its purchasing and payables systems. Students are asked to evaluate creating a shared services system or outsourcing the entire processing. Costs are presented as ranges rather than point estimates, requiring students to deal with uncertainty and ambiguity in the evaluation process.
Dennis Caplan, “John Adams, Thomas Jefferson, and the Barbary Pirates: An Illustration of Relevant Costs for Decision Making.” Issues in Accounting Education, August 2003, 265-273.
Students explore the concept of relevant costs using an historical context.
Luann J. Lynch, “FinePrint Company,” Darden Business Publishing,
This is a set of three cases (UVA-C-2193, UVA-C-2194, UVA-C-2195) that explores special orders and outsourcing.
Critical Thinking Exercises
Read Sarah Johnson, “Rethinking Risk in Offshore Outsourcing Deals,” CFO.com, September 2, 2009 (available online at
Questions
- How do exchange rates affect the cost of offshore outsourcing?
If offshore outsourced services are paid for in the local currency and the dollar weakens relative to the local currency, the cost of the services will increase. However, if the dollar strengthens relative to the local currency, the cost of the services will decrease.
- How can a company that offshores services reduce the exchange rate risk?
Exchange rate risk can be mitigated by negotiating a contract that is paid in dollars rather than the local currency. Alternatively, the contract may provide for early renegotiation if exchange rates fluctuate dramatically.
Read J. Lynn Lunsford, “Jet Blues: Boeing Scrambles to Repair Problems with New Plane,” The Wall Street Journal, December 7, 2007; Peter Sanders, “Boeing Sets Deal to Buy a Dreamliner Plant,” The Wall Street Journal, July 8, 2009 and Kyle Peterson, “Boeing 787 Delays Cast Hard Light on Outsourcing,” Thomson Reuters, September 11, 2009 (available online at
Questions
- Boeing charted new ground in outsourcing its 787 Dreamliner aircraft. What has gone wrong with the outsourcing approach?
While Boeing had outsourced some manufacturing of its aircraft components before, it had never done so on such a large scale. Additionally, Boeing outsourced design as well as manufacturing, and it was not able to adequately control the quality of the outsourced components. (Some estimates from other new sources place the outsourcing as high as 60% of the total design and manufacturing effort.)
Several of the outsourced suppliers in turn outsourced work to subcontractors, a move that Boeing did not anticipate. As these subcontractors received more work from multiple vendors, their ability to produce work in a timely manner was compromised.
With a truly global supply chain of approximately 50 firms producing components that are shipped to Boeing’s Everett, Washington, facility for final assembly, unforeseen problems ranged from suppliers’ problems getting manufacturing facilities started to language barriers.
- Boeing’s original roll out date of the first 787 Dreamliner was July 8, 2007. As of this writing, the revised delivery date for the first aircraft is the middle of the first quarter, 2011. What effect do you think this delay will have on Boeing?
As a result of the ongoing delays, some customers have cancelled orders. This action will reduce the income Boeing receives from the new aircraft. It has spent millions on assisting its suppliers in solving production issues. The delays have also affected on Boeing’s reputation with its customers and suppliers. With most of the suppliers committed to a 30-year relationship on the 787 project, Boeing must develop a plan for maintaining these critical relationships. And if this model is to be followed on future aircraft projects, as indicated in the articles, Boeing must revisit how the outsourced relationships are governed and managed from inception.
Read Dana Mattioli, “From Snowmobiles to Cellphones, a Scramble for Parts,” The Wall Street Journal, August 5, 2010
Questions
- What is the constrained resource in this article?
The article discusses shortages of several electronics components used by various manufacturers.
- How have the companies mentioned in the article been affected by the raw materials constraint?
Some manufacturers have had to reduce production and have experienced lost sales. Others have switched production to products that do not require the constrained input. Still others have worked with other suppliers to develop alternative input components.
- What can the companies do to avoid a similar situation in the future?
Companies can explore using multiple suppliers for critical components or might consider bringing production of these critical components in house rather than relying on outside suppliers.
PowerPoint Slide Notes
/ C&C Sports has been looking for ways to improve its profits. The company faces several decisions that will have an impact on profits. Talk about each of these four decisions and how they might impact profits./ Discuss the idea of relevant information. Ask why we need to identify relevant information and relate it to information overload. Focus on the two criteria for relevant information – differs between alternatives and makes a difference in the future.
/ Ask students to identify which of these pieces of information would be relevant to purchasing one of these two cars.
/ Reiterate the characteristics of relevant information. Discuss sunk costs and how they are never relevant to a decision.
/ Review avoidable and unavoidable costs.
/ Ask students to identify the relevant information for this decision. List their responses on the board.
/ Review the students’ responses. If someone identified the relevant cost to drive as $0.15 per mile, discuss why this is not the correct cost because the fixed cost of $1,000 will not differ between the two alternatives.
/ Discuss why this is the correct comparison to make using relevant costs. Also ask what other information might have an impact on the decision, such as transportation to and from the airport if you fly and additional time required to drive.
/ Again, reiterate that sunk costs are not relevant.
/ Present this general model for decision making.
/ Ask students if they have ever used websites such as Priceline or Hotwire to “name their own” price for hotels, airline tickets, or rental cars. Ask why these vendors are willing to entertain such a business model that sells their products/services at a price less than the normal retail price. Discuss how this practice is a special order pricing decision.
/ Discuss the factors that might lead a company to accept a special order price that is lower than the regular price.
/ Students need to understand that there are qualitative issues to accepting a special order price.
/ Work through this simple example to illustrate how to make a special order pricing decision using relevant information.
/ Review the factors of the special order pricing decision. Point out that a company will not remain viable if all orders are treated this way. For example, if the variable cost for adding an additional passenger on a flight is, say, $75, why won’t airlines just let passengers walk up at the last minute and buy a ticket for $80?
/ Discuss the difference between outsourcing and offshoring. The two terms are often used interchangeably, although they are different approaches to doing business.
/ Discuss the relevant costs to consider in an outsourcing decision. The key is understanding the avoidable costs.
/ Use this simple example to highlight the idea of avoidable costs and the problems that arise when looking at fixed cost per unit.
/ Highlight the fact that fixed costs can be avoidable.
/ Often an outsourcing decision results in “freed up” production capacity that can be used to produce additional products and generate additional contribution margin. This opportunity cost must be considered when making the outsourcing decision.
/ Use this simple example to illustrate the impact of opportunity costs in the outsourcing decision.
/ Discuss the qualitative factors that must be considered in an outsourcing decision. Ask students if they have had experience with outsourced/offshored arrangements that have failed to meet their expectations and to consider how their experience has affected their ongoing relationship with that organization.
/ Review the factors in the outsourcing decision.
/ Ask students what resource constraints they face and how they allocate those resources (for example, how do they allocate limited study time across all classes). Then talk about some of the resource constraints that organizations face. For example, recent articles in the business press have mentioned shortages of essential electronic components for many manufacturers. Then discuss the contribution margin per unit of constrained resource.
/ Use this simple example to illustrate how to identify a constrained resource and how to allocate that resource to maximize total contribution margin.
/ Ask why Wendy wouldn’t produce as many kites as possible – if there is no demand, there is no reason to produce. Explore what actions Wendy might take to obtain enough banners to meet customer demand – overtime, purchase more sewing machines, hire more workers, outsource production.
/ Review the factors of the constrained resource allocation decision.
/ Discuss how organizations continually evaluate the profitability of segments and contemplate adding new segments. With traditional income statements, the issue becomes understanding which costs are direct to the segment and which are allocated.
/ Discuss how to identify direct costs of a segment, and reinforce that these can be fixed or variable. It is only these direct avoidable costs that should be considered when evaluating a segment’s profitability. Define segment margin and relate it to contribution margin.
/ Use this simple example to identify relevant costs. Point out that by looking only at the operating income, Departments B and C appear to be unprofitable. It appears that dropping these two departments should increase operating income by $6,000.
/ This report shows the segment margin for each department and illustrates the use of segment margin for assessing profitability. It shows that Department C is actually contributing $5,000 toward the company’s fixed costs. Department B still appears unprofitable and may be a candidate for elimination. But managers will want additional information such as income trends and product complementarity before making the final decision on closing this department.
/ Review the factors of the product line decision.
8-1