Course Notes Chapter 7
CHAPTER 7
THE USE OF COST INFORMATION IN MANAGEMENT DECISION MAKING
Chapter Introduction
BEFORE MAKING DECISIONS, MANAGERS MUST GAIN A THOROUGH UNDERSTANDING OF THE COST INFORMATION THAT IS RELEVANT. PREVIOUS CHAPTERS HAVE EXAMINED VARIOUS ISSUES INVOLVING COSTS. THIS CHAPTER DISCUSSES THE TOPIC OF HOW COST INFORMATION IS USED BY MANAGERS IN DECISION MAKING.
Objectives, Terms, and Discussions
LO1 Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions.
INCREMENTAL ANALYSIS
All decisions involve a choice among alternative courses of action. The solution to all business problems involves incremental analysis—the analysis of the incremental revenue generated and the incremental costs incurred when one decision alternative is chosen over another. Incremental revenue is the additional revenue received as a result of selecting one decision alternative over another. Incremental cost (also referred to as relevant cost or differential cost) is the additional cost incurred as a result of selecting one decision alternative over another. Incremental costs are also referred to as relevant costs because they are the only costs that are relevant when analyzing decision alternatives or differential costs because they are the costs that differ between decision alternatives. If an alternative generates an incremental profit (incremental revenue less incremental costs) then it should be selected. For example, assume that Jensen Rapid Copy is open from 6 a.m. until 8 p.m. The owner is trying to decide whether or not to extend hours until midnight. There is a choice of two alternatives: closing at 8 p.m. or closing at midnight. Jensen estimates that with the longer hours, revenue will increase by $288,000. However, labor, paper, toner and other supplies, utilities, and insurance will increase by $232,981. Since incremental profit is positive, staying open is the preferred alternative. Note that
THE USE OF COST INFORMATION IN MANAGEMENT DECISION MAKING
Chapter Introduction
BEFORE MAKING DECISIONS, MANAGERS MUST GAIN A THOROUGH UNDERSTANDING OF THE COST INFORMATION THAT IS RELEVANT. PREVIOUS CHAPTERS HAVE EXAMINED VARIOUS ISSUES INVOLVING COSTS. THIS CHAPTER DISCUSSES THE TOPIC OF HOW COST INFORMATION IS USED BY MANAGERS IN DECISION MAKING.
Objectives, Terms, and Discussions
LO1 Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions.
INCREMENTAL ANALYSIS
All decisions involve a choice among alternative courses of action. The solution to all business problems involves incremental analysis—the analysis of the incremental revenue generated and the incremental costs incurred when one decision alternative is chosen over another. Incremental revenue is the additional revenue received as a result of selecting one decision alternative over another. Incremental cost (also referred to as relevant cost or differential cost) is the additional cost incurred as a result of selecting one decision alternative over another. Incremental costs are also referred to as relevant costs because they are the only costs that are relevant when analyzing decision alternatives or differential costs because they are the costs that differ between decision alternatives. If an alternative generates an incremental profit (incremental revenue less incremental costs) then it should be selected. For example, assume that Jensen Rapid Copy is open from 6 a.m. until 8 p.m. The owner is trying to decide whether or not to extend hours until midnight. There is a choice of two alternatives: closing at 8 p.m. or closing at midnight. Jensen estimates that with the longer hours, revenue will increase by $288,000. However, labor, paper, toner and other supplies, utilities, and insurance will increase by $232,981. Since incremental profit is positive, staying open is the preferred alternative. Note that