C.2. Marginal Analysis and Decision Making

Question 1

What is marginal analysis?

Answer 1

Examination of how benefits and costs respond to a very small, typically one-unit change in output or input.

It is used to determine whether the expected added benefit of a one-unit change is greater than the expected added cost of the change.

Question 2

Define:

Marginal Revenue

Answer 2

The additional revenue from a one-unit increase in activity.

It is calculated as total revenue after the one-unit activity increase minus total revenue before the activity increase.

Question 3

What are relevant revenues and costs?

Answer 3

Future revenues and costs that differ between or among alternatives.

Any future revenue or cost that will be the same regardless of which alternative is chosen is not relevant.

Question 4

What is a sunk cost?

Answer 4

A cost for which the money has already been spent and cannot be recovered.

Sunk costs are not relevant to decision-making because they are past costs and cannot be changed by any decision made currently.

Question 5

What is the difference between differential and incremental costs?

Answer 5

• Differential costs differ between two alternatives
• Incremental costs are incurred additionally because of an activity

Question 6

What is an avoidable cost?

Answer 6

An existing cost that can be avoided if a particular option is selected.

Avoidable costs are relevant to decision-making because they will continue if one course of action is taken but will not continue if a different course of action is taken.

Question 7

Define:

Opportunity Cost

Answer 7

The benefit that could have been gained from an alternative use of the same resource.

It is the contribution to income that is lost when a limited resource is not used in its best alternative use.

An opportunity cost is an implicit cost and is relevant in decision-making. It represents earnings forgone because of choosing one alternative over another. Opportunity cost is calculated as the difference between the revenues that would not be received and expenditures that would not be made for the other available alternative.

Question 8

True or False:

Unavoidable costs are relevant to decision-making.

Answer 8

False

Unavoidable costs are not relevant because they do not differ between alternatives. They will be the same regardless of what decision is made.

Question 9

What is a cost object?

Answer 9

Any item or activity for which costs can be measured.

Examples include a product, a batch of like units, a customer order, a contract, a product line, a process, a department, a division, a project, real property, or a strategic goal.

Question 10

How is a direct cost defined?

Answer 10

Costs incurred specifically because of a cost object and can be traced directly to it.

Question 11

What is cost allocation?

Answer 11

The process of assigning indirect costs to cost objects according to a predetermined formula or allocation base.

Question 12

What factors affect whether a cost is classified as direct or indirect?

Answer 12

• Materiality
• Technology
• Organizational design
• Contractual arrangements

Materiality: Is it economically feasible to trace a cost to a particular cost object?

Technology: Can technology make it economically feasible to trace costs that otherwise would be considered indirect costs?

Organizational design: Is a given facility used exclusively for a specific cost object?

Contractual arrangements: Does a contract specify a specific component for use in a product?

Question 13

Define:

What are variable costs?

Answer 13

Costs that change in total with activity level but remain constant per unit.

Question 14

What are fixed costs?

Answer 14

Costs that do not change in total within a designated range, known as the relevant range, while the cost per unit changes as the volume changes.

Question 15

What are mixed costs?

Answer 15

A combination of fixed and variable elements and may be semi-variable or semi-fixed (step) costs.

Question 16

What is a semi-variable cost?

Answer 16

Cost that has both a fixed component and a variable component. A basic fixed amount must be paid regardless of activity, even if there is no activity; and in addition to that fixed amount there is a variable charge based on activity.

Question 17

What is a semi-fixed cost?

Answer 17

Also called a step variable cost, it moves upward in a step fashion, staying at a certain level over a small range of activity and then moving to the next level quickly.

All fixed costs behave this way, but a semi-fixed cost is fixed over a smaller relevant range than the relevant range of a wholly fixed cost.

Question 18

What is a cost driver?

Answer 18

A characteristic of an activity that affects costs, such as a given level of activity or volume over a given time span. It is anything that causes costs to be incurred each time it occurs.

Question 19

What is an imputed cost?

Answer 19

Also called an implicit cost, it does not show up in accounting records and does not entail a cash outlay but must be considered in decision making.

Question 20

How does income tax affect decision making in incremental analysis?

Answer 20

Income tax effects must be factored into the analysis, reducing net incremental revenue by the tax liability and reducing net incremental expense by the tax benefit.

Question 21

What is a depreciation tax shield?

Answer 21

The tax savings resulting from depreciation expense, calculated as the depreciation amount multiplied by the company’s tax rate.

Question 22

What is incremental and differential analysis?

Answer 22

The process of choosing between or among two or more alternatives based on which opportunities will provide the most benefit.

Question 23

What is the focus of incremental and differential analysis?

Answer 23

Incremental or differential revenues and costs, which are the only relevant revenues and costs.

Question 24

What are make-or-buy decisions?

Answer 24

Decisions on whether to produce a product or component in-house or purchase it from an outside vendor, considering relevant costs and other, qualitative, factors.

Question 25

What costs are considered relevant in make-or-buy decisions?

Answer 25

* Variable costs * Avoidable fixed costs * Opportunity costs

Question 26

What are relevant costs in decision-making?

Answer 26

* Avoidable variable and fixed costs * Opportunity costs ## Footnote Relevant costs are those that will change as a result of a decision, such as costs that can be avoided or opportunity costs that represent potential benefits foregone by choosing one alternative over another.

Question 27

What are irrelevant costs in decision-making?

Answer 27

* Unavoidable fixed costs * Sunk costs ## Footnote Irrelevant costs do not affect the decision-making process because they remain the same regardless of the decision made.

Question 28

How is the maximum price to pay an outside supplier determined?

Answer 28

Maximum Price to Pay = Total Internal Production and Other Costs Including Opportunity Costs − Unavoidable Fixed and Variable Costs

Question 29

What factors should be considered in a make-or-buy decision?

Answer 29

* Total relevant costs per unit * Opportunity costs * Unavoidable costs * Qualitative factors ## Footnote A make-or-buy decision involves comparing the cost of producing an item internally with the cost of purchasing it externally, considering both quantitative and qualitative factors.

Question 30

What qualitative factors might affect a make-or-buy decision?

Answer 30

* Product quality * Reliability of delivery * Service * Flexibility in delivery terms * Impact on relations with current customers and with the public ## Footnote Qualitative factors, while difficult to quantify, can significantly impact the decision-making process and should be carefully evaluated.

Question 31

What is a special order decision?

Answer 31

A decision regarding whether to accept or reject a one-time order at a specified price.

Question 32

What factors should be considered in making a decision to accept or reject a special order?

Answer 32

* The incremental direct costs of production * The level of capacity at which the company is currently operating, in order to determine if opportunity cost is a factor

Question 33

What costs are considered in determining the minimum price for a special order?

Answer 33

The minimum price for a special order must cover all the costs that will be directly incurred in fulfilling it. * Incremental direct costs of production * Opportunity costs (if operating at full capacity) ## Footnote The minimum price must cover all avoidable costs directly incurred by the special order and any lost contribution from other products that won't be able to be produced if capacity is already fully utilized.

Question 34

How does operating capacity affect special order pricing?

Answer 34

If operating at full capacity, the price must cover both direct costs and lost contribution from other products that cannot be produced and sold if the special order is accepted. If not at full capacity, only direct costs need to be covered. ## Footnote Operating capacity determines whether opportunity costs need to be included in the pricing of a special order.

Question 35

What is the effect on operating income of accepting a special order with idle capacity?

Answer 35

Operating income increases if the special order price exceeds the incremental, avoidable costs of production. ## Footnote When there is idle capacity, the special order can add to operating income without displacing other production.

Question 36

What is the effect on operating income of accepting a special order at full capacity?

Answer 36

Operating income increases if the special order price exceeds both direct costs and the lost contribution from displaced production. ## Footnote At full capacity, accepting a special order involves opportunity costs from not producing other items.

Question 37

What is a joint production process?

Answer 37

A single production process that yields more than one product. ## Footnote An example is crude oil processing, which can produce gasoline, diesel fuel, and other petrochemicals.

Question 38

What is the split-off point in a joint production process?

Answer 38

The point where the various products become individually identifiable.

Question 39

What are **joint costs**?

Answer 39

Costs incurred up to the split-off point in a joint production process.

Question 40

What are separable processing costs?

Answer 40

In a joint production process, these are costs incurred for each product after the split-off point.

Question 41

In a sell or process further decision, what should be compared?

Answer 41

Incremental revenue from further processing versus incremental costs of further processing. ## Footnote If the incremental revenue from further processing exceeds the incremental costs of further processing, the product should be processed further, assuming the production can be sold.

Question 42

# True or False: Joint costs are relevant in deciding whether to sell at the split-off point or process further.

Answer 42

False ## Footnote Joint costs are sunk costs and should not be considered in the decision.

Question 43

What is **disinvestment**?

Answer 43

The action of selling or liquidating an asset or, without selling the asset, reducing capital investments in it.

Question 44

What is the difference between disinvestment and divestment?

Answer 44

* Disinvestment can mean selling or liquidating an asset or segment of a business, but it can also mean reducing capital investments in an asset or a segment without selling it. * Divestment means selling or disposing of an asset.

Question 45

What are unavoidable costs in a disinvestment decision?

Answer 45

Costs that will continue even if a product or segment is terminated.

Question 46

What are avoidable costs in a disinvestment decision?

Answer 46

Costs incurred only if the division continues to operate.

Question 47

What is **marginal cost**?

Answer 47

The increase in total cost incurred by increasing production by one unit.

Question 48

What is **marginal profit**?

Answer 48

Marginal revenue minus marginal cost.

Question 49

What is **marginal product**?

Answer 49

Also called marginal physical product, it is the additional output that is produced by adding one more unit of an input.

Question 50

What is marginal resource cost?

Answer 50

The increase in total cost of a resource that results from using one additional unit of the resource.

Question 51

What is marginal revenue product?

Answer 51

The increase in total revenue that arises from using one additional unit of a resource.

Question 52

What is the profit-maximizing condition for output?

Answer 52

To maximize profit, output should be planned so that: Marginal Revenue (MR) = Marginal Cost (MC) ## Footnote To maximize profits, the company should expand production if the marginal revenue from producing and selling one more unit exceeds the unit’s marginal cost, since selling additional units up to that point will cause total profit to increase.

Question 53

What happens if production is expanded beyond the point where Marginal Revenue = Marginal Cost?

Answer 53

Sales beyond the point where MR = MC produce a loss on each additional (or marginal) item sold, decreasing total profits. ## Footnote Beyond the point where MR = MC, the marginal cost of production exceeds the marginal revenue, leading to a decrease in total profit.

Question 54

# Define: The Law of Diminishing Returns

Answer 54

As the amount of a resource put into the production process increases, the increase in total production resulting from each additional unit of input decreases. ## Footnote This principle governs the optimal, profit-maximizing use of variable inputs to maximize profit.

Question 55

What is the rule for employing resources to maximize profit?

Answer 55

Resources should be added until the marginal revenue product from adding a resource equals the marginal resource cost of adding the resource.

Question 56

What is marginal resource cost?

Answer 56

The increase in total cost of a resource that results from using one additional unit of the resource.

Question 57

# True or False: A company should continue adding resources until the marginal revenue product from adding a resource equals the marginal resource cost of adding the resource.

Answer 57

True ## Footnote This ensures that each additional unit of resource added contributes more to total revenue than to total cost, thus maximizing profit.