chapter 3 summary

Chapter 3
Using costs in decision making
1 How Management accounting supports internal decision making
●Pricing-market-determined price, cost plus pricing.
●Product Planning-target costing.
●Budget
●Performance
●Contracting-In cost reimbursement contracts organizations are reimbursed their cost plus anincrement for the goods or service they provide under the contract.
2 Variable and fixed costs
Variable cost-A variable cost is one that increases proportionally with changes in the activity levelof some variable.
Variable cost =Variable cost per unit of the cost driver *Cost driver units.
Fixed cost-A fixed cost is a cost that does not vary in the short run with a specified activity. Total cost =Variable cost +Fixed cost
3 Cost- Volume –Profit Analysis
Agood understanding of cost and revenue behavior is critical in providing decisionmakers with an understanding of the relationship betwe en a project’s revenues, costs,and profits.
Profit =Revenue -Total costs =Revenue -Variable costs -Fixed costs
4 Developing and Using the CVP equation
The difference between total revenue and total variable cost is called the contribution margin. The contribution margin per unit is the contribution that eachunit makes to covering fixed costs and providing a profit.
Profit =Unit sales *(Price per unit $ Variable cost per unit)-$ Fixed costor
Profit =Contribution margin per unit *Units produced and sold-Fixed costs
units needed to be sold =(target profit + fixed cost) /contribution margin per unit
5 Other useful cost definitions
Mixed cost- A mixed cost is a cost that has a fixed component and a variable component. Step variable costs- A step variable cost increases in steps as quantity increases.
Incremental cost -An incremental cost is the cost of the next unit of production and is similar to the economist’s notion of marginal cos t.
Sunk cost- A sunk cost is a cost that results from a previous commitment and cannot berecovered.
Relevant cost-A relevant cost is a cost that will change as a result of some decision.
Opportunity cost-Opportunity cost is the maximum value forgonewhen a course of action is chosen.
Avoid cost-A cost that can be avoided by undertaking some course of action is called
an avoidable cost. The most obvious avoidable costs are variable costs. If productionceases all variable costs associated with that production process are avoided.
With these ideas in mind, we now turn to consider how these various costconcepts (sunk, relevant, opportunity, and avoidable) occur in common managementdecisions.We will look atfour types of decisions where these concepts provide usefulinsights:
. Make versus buy decisions and outsourcing.
. Decision to drop a product.
. Costing order decisions—the floor price.
. Short-term product mix decisions (with constraints).
6 Make-Or- Buy –The outsourcing Decision
Deciding whether to contract out for a product orservice is known as the make-or-buy decision.Many qualitative considerations go into a make-or-buy decision. These includethe reliability of the supplier in meeting quality and delivery requirements and thestrategic importance of the activity being outsourced.
Manufacturing Costs
Direct materials
Direct labor
Manufacturing overhead
7 The Decision to Drop A Product
Organizations abandon a product when it is unprofitable either because revenues nolonger exceed costs or because another organization offers to buy the rights to theproduct at a favorable price.
8 Costing Orders
Different examples illustrate management accounting in decision making.
The chapter also introduced the decision-makingprinciple that the only relevant items in a decision arethose costs that change as a result of the decision. Therelevant cost concept was explored in the contextof the make-or-buy decision, the decision to drop aproduct or department, the order decision, and theshort-term product mix decision.The discussion in the chapter pointed out thatpractice frequently witnesses violations of therelevant cost principle—one of the most commonviolations being the sunk cost phenomenon. The consequenceis that decision makers need to avoid introducingirrelevant data into their decision making.。