Unit VI

Managerial Accounting Techniques for Planning, Controlling, and Decision

Making
1. Cost-Volume-Profit Relationship
2. Responsibility Accounting
3. Transfer Pricing
4. Master Budgeting
5. Opportunity Costing/Differential Analysis
 Costs are an important feature of many business decisions. In making decisions, it is
essential to have a clear understanding of the concepts of differential cost, and
opportunity cost.

 Opportunity Costing (Slide 2)

Opportunity cost is the potential benefit that is given up when one alternative is
selected over another. To illustrate this important concept, consider the following
examples:

Example 1
Vicki, a university student, has a part-time job that pays her $200 per week. She
would like to spend a week at the beach during the study break, and her employer
has agreed to give her the time off, but without pay. The $200 in lost wages would
be an opportunity cost of taking the week off to be at the beach.

Example 2
Steve is employed with a company that pays him a salary of $40,000 per year. He is
thinking about leaving the company and returning to school. Since returning to
school would require that he give up his $40,000 salary, the forgone salary is an
opportunity cost of getting further education.

Kumbaga yung kelangan mo isakripisyo jowa mo sa para sa pangarap mo.

Opportunity costs are not usually entered in the accounting records of an

organization, but they must be explicitly considered in every decision a manager
makes. Virtually every alternative has an associated opportunity cost. In Example 2,
for instance, if Steve decides to stay at his job, an opportunity cost is still involved—
the higher income that could be realized in future years as a result of returning to
school.

 Differential Analysis
o Decisions involve choosing among alternatives. In business decisions, each
alternative has certain costs and benefits that must be compared to the costs
and benefits of the other available alternatives. (Parang mahal ko or mahal
 ako). A difference in costs between any two alternatives is known as a
differential cost. A difference in revenues between any two alternatives is
known as differential revenue.

A differential cost is also known as an incremental cost, although technically

an incremental cost should refer only to an increase in cost from one
alternative to another; decreases in cost should be referred to as
decremental costs. Differential cost is a broader term, encompassing both
cost increases (incremental costs) and cost decreases (decremental costs)
between alternatives.

o Keep or Drop a Product Segment

o Make or Buy
 Many steps may be involved in getting a finished product into the
hands of a consumer. First, raw materials may have to be
obtained through mining, drilling, growing crops, raising animals,
and so forth. Second, these raw materials may have to be
processed to remove impurities and to extract the desirable and
usable materials. Third, the usable materials may have to undergo
some preliminary conversion so as to be usable in final products.
For example, cotton must be made into thread and textiles before
being made into clothing. Fourth, the actual manufacturing of the
finished product must take place. And, finally, the finished
product must be distributed to the ultimate consumer. Each of
these steps is part of the value chain.

A decision to produce internally, rather than to buy externally

from a supplier, is called a make or buy decision. Indeed, any
decision relating to vertical integration is a make or buy decision,
since the company is deciding whether to meet its own needs
internally or to buy externally.

An Example of Make or Buy

To illustrate a make or buy decision, let’s consider OSN Cycles.
The company is now producing the heavy-duty gear shifters used
in its most popular line of mountain bikes. The company’s
Accounting Department reports the following costs of producing
the shifter internally:
Slide 6
An outside supplier has offered to sell OSN Cycles 8,000 shifter per year at a price of
only $19 each. Should the company stop producing the shifters internally and start
purchasing them from the outside supplier? To approach the decision from a
financial point of view, the manager should again focus on the differential costs. As
we have seen, the differential costs can be obtained by eliminating those costs that
are not avoidable—that is, by eliminating (1) the sunk costs and (2) the future costs
that will continue regardless of whether the shifters are produced internally or
purchased outside. The costs that remain after making these eliminations are the
costs that are avoidable to the company by purchasing outside. If these avoidable
costs are less than the outside purchase price, then the company should continue to
manufacture its own shifters and reject the outside supplier’s offer. That is, the
company should purchase outside only if the outside purchase price is less than the
costs that can be avoided internally as a result of stopping production of the shifters.

Looking at the data, note first that depreciation of special equipment is listed as one
of the costs of producing the shifters internally. Since the equipment has already
been purchased, this depreciation is a sunk cost and is therefore irrelevant. If the
equipment could be sold, its salvage value would be relevant. Or if the machine
could be used to make other products, this could be relevant as well. However, we
will assume that the equipment has no salvage value and that it has no other use
except in making the heavy-duty gear shifters. Also note that the company is
allocating a portion of its general overhead costs to the shifters. Any portion of this
general overhead cost that would actually be eliminated if the gear shifters were
purchased rather than made is relevant in the analysis. However, it is likely that the
general overhead costs allocated to the gear shifters are in fact common to all items
produced in the factory and would continue unchanged even if the shifters were
purchased from outside. Such allocated common costs are not differential costs
(because they do not differ between the make and buy alternatives) and should be
eliminated from the analysis along with the sunk costs. The variable costs of
producing the shifters (materials, labor, and variable overhead) are differential costs,
because they can be avoided by buying the shifters from the outside supplier. If the
supervisor can be laid off and her salary avoided by buying the shifters, then her
salary will be a differential cost and relevant to the decision. Assuming that both the
variable costs and the supervisor’s salary can be avoided by buying from the outside
supplier, the analysis takes the form shown (Slides 7) in Exhibit 12–5. Since it costs
$5 less per unit to continue to make the shifters, OSN Cycles should reject the
outside supplier’s offer. However, there is one additional factor that the company
may wish to consider before coming to a final decision. This factor is the opportunity
cost of the space now being used to produce the shifters. If the space now being
 used to produce the shifters would otherwise be idle , then OSN Cycles should
continue to produce its own shifters and the supplier’s offer should be rejected, as
stated above. Idle space that has no alternative use has an opportunity cost of zero.
But what if the space now being used to produce shifters could be used for some
other purpose? In that case, the space has an opportunity cost that must be
considered in assessing the desirability of the supplier’s offer. What is this
opportunity cost? It is the segment margin that could be derived from the best
alternative use of the space. To illustrate, assume that the space now being used to
produce shifters could be used to produce disc brakes that would generate a
segment margin of $60,000 per year. Under these conditions, OSN Cycles would be
better off to accept the supplier’s offer and to use the available space to produce the
new product line: (Slides 8)

Opportunity costs are not recorded in the accounts of an organization because they do not
represent actual dollar outlays. Rather, they represent economic benefits that are forgone as a
result of pursuing a particular course of action. Because of this, opportunity costs are often
erroneously ignored by managers when making decisions. The opportunity costs of OSN Cycles
are sufficiently large in this case to make continued production of the shifters very costly from
an economic point of view.

 Accept or Reject Special Order

o Managers must often evaluate whether a special order
should be accepted, and if the order is accepted, what
price should be charged. A special order is a one-time
order that is not considered part of the company’s normal
ongoing business. The objective in setting a price for
special orders is to achieve positive incremental operating
income.
To illustrate, OSN Cycles has just received a request from the police department of a large
Canadian city to produce 100 specially modified mountain bikes at a price of $560 each. The
bikes would be used to patrol some of the more densely populated residential sections of the
city. OSN Cycles can easily modify its City Cruiser model to fit the specifications of the police
department. The normal selling price of the City Cruiser bike is $700, and its unit product cost is
$564, as shown below:

(Slide 11) The variable portion of the above manufacturing overhead is $12 per unit. The order
would have no effect on the company’s total fixed manufacturing overhead costs. The
modifications to the bikes consist of welded brackets to hold radios, nightsticks, and other gear.
These modifications would require $34 in incremental variable costs per unit. In addition, the
company would have to pay a graphic design studio $1,200 to design and cut stencils that
would be used for spray painting the police department’s logo and other identifying marks on
the bikes.

This order should have no effect on the company’s other sales. The production manager says
that he can handle the special order without disrupting any of the regular scheduled
production. What effect would accepting this order have on the company’s operating income?
Only the incremental costs and benefits are relevant. Since the existing fixed manufacturing
overhead costs would not be affected by the order, they are not incremental costs and
therefore are not relevant. The incremental operating income can be computed as follows:
Therefore, even though the price on the special order ($560) is below the normal unit product
cost ($564) and the order would require incurring additional costs, it would result in an increase
in operating income. In general, a special order is profitable as long as the incremental revenue
from the special order exceeds the incremental costs of the order. However, in performing the
analysis it is important to make sure that there is indeed idle capacity and that the special order
does not affect the company’s ability to meet normal demand. For example, what if OSN Cycles
is already operating at 100% of capacity and normally sells all the bikes it can produce for $700
each? What is the opportunity cost of accepting the order? Should the company accept the
$560 price? If not, what is the minimum price it should accept? To answer these questions, the
analysis can be conducted as follows:

Since the total relevant costs of $746 exceed the offer price of $560, OSN Cycles should decline
the offer. Indeed, to be no worse off from a financial perspective, the minimum price that
should be charged on the special order is $746 per bike. At this price, management should be
indifferent between filling the special order and continuing to sell all it can produce to regular
customers.