Decision Making - Applying Marginal Analysis

Question 1

CMA test tip in applying marginal analysis to decision making

Answer 1

When applying marginal analysis to decision making, a CMA candidate must be able to easily identify avoidable and unavoidable costs

Unavoidable costs have no relevance to the decision-making process to drop or add a segment

This may seem simple, but a typical CMA exam question will not include whether the costs are relevant or irrelevant and you must be able to readily identify them as such, calculate the cost and recommend a course of action

Incorrectly identifying a cost for whatever reason could easily lead to an incorrect calculation and evaluation of the situation

Question 2

What is the criteria for revenues and costs to be considered relevant?

Answer 2

In decision making, an organization must focus on only relevant revenues and costs. To be relevant, the revenues and costs must:

1. Be made in the future
2. Differ among the possible alternative courses of action
3. Only avoidable costs are relevant
4. Incremental (marginal or differential) costs are inherent in the concept of relevance
5. Relevant cost determination is NOT the use of unit revenues and costs - emphasis should be placed on total relevant revenues and costs (not unit)

Question 3

How are costs made in the future deemed to be considered relevant in decision making?

(Criteria for revenues and costs to be considered relevant)

Answer 3

Costs that have already been incurred or to which the organization is committed (called sunk costs) have no bearing on any future decisions

Example: A manufacturer is considering upgrading its production equipment owning to the obsolescence of its current machinery. The amounts paid for the existing equipment are sunk costs; they make no difference in the decision to modernize

Question 4

How are costs that differ among the possible alternative courses of action considered relevant in decision making?

(Criteria for revenues and costs to be considered relevant)

Answer 4

Example: A union contract may require 6 months of wage continuance in case of a plant shutdown. Thus, 6 months of wages must be disbursed, regardless of whether the plant remains open

Question 5

How are only avoidable costs are relevant in decision making?

(Criteria for revenues and costs to be considered relevant)

Answer 5

Only AVOIDABLE costs are relevant

An avoidable cost may be saved by NOT adopting a particular option. Avoidable costs might include variable raw material costs and direct labor costs

An unavoidable cost is one that cannot be avoided if a particular action is taken

For example: If a company has a long-term lease on a building, closing out the business in that building will not eliminate the need to pay rent. Thus, the rent is an unavoidable cost

Question 6

How are incremental costs inherent in the concept of relevance?

(Criteria for revenues and costs to be considered relevant)

Answer 6

Incremental (marginal or differential) costs are inherent in the concept of relevance

Throughout the relevant range, the incremental cost of an additional unit of output is the same. Once a certain level of output is reached, however, the current production capacity is insufficient and another increment of fixed costs must be incurred

Question 7

Why should relevant cost determination NOT use unit revenues and costs in decision making?

(Criteria for revenues and costs to be considered relevant)

Answer 7

Relevant cost determination is NOT the use of unit revenues and costs - emphasis should be placed on total relevant revenues and costs (not unit)

The emphasis should be on total relevant revenues and costs because unit data may include irrelevant amounts or may have been computed for an output level different from the one for which the analysis is being made

Question 8

What cautions must be considered when applying marginal analysis?

Answer 8

Caution always must be used in applying marginal analysis because of the following considerations:

1. Special price concessions place the firm in violation of the price discrimination provisions of the Robinson-Patman Act of 1936
2. Government contract pricing regulations apply
3. Sales to a special customer affect sales in the firm’s regular market
4. Regular customers learn of a special price and demand equal terms
5. Disinvestment (i.e. dropping a product line) will hurt sales in the other product lines (i.e. the dropped product may have been an unintended loss leader)
6. An outsourced product’s quality is acceptable and the supplier is reliable
7. Employee morale may be affected. If employees are laid off or asked to work too few or too many hours, morale may be affected favorably or unfavorably

Question 9

How are disinvestment decisions different from capital budgeting decisions?

Answer 9

Disinvestment decisions are the opposite of capital budgeting decisions (i.e. to terminate an operation, product or product line, business segment, branch or major customer rather than start one)

In general, if the marginal cost of a project exceeds the marginal revenue, the firm should disinvest

Question 10

What are the 4 steps that should be taken in making a disinvestment decision?

Answer 10

4 steps should be taken in making a disinvestment decision:

1. Identify fixed costs that will be eliminated by the disinvestment decision (i.e. insurance on equipment used)
2. Determine the revenue needed to justify continuing operations. In the short-run, this amount should at least equal the variable cost of production or continued service
3. Establish the opportunity cost of funds that will be received upon disinvestment (i.e. salvage value)
4. Determine whether the carrying amount of the assets is equal to their economic value. If not, reevaluate the decision using current fair value rather than the carrying amount

Note: When a firm disinvests, excess capacity exists unless another project uses this capacity immediately. The cost of idle capacity should be treated as a relevant cost