The Cost Accounting Decision Model

In cost accounting, a decision model is a process for making important decisions. Most types of organizations (businesses, sports teams, and governments, to name a few) have a formal process for making choices. Some of this, of course, is common sense. Here are the steps in a typical decision model:

  1. Define the problem.

  2. Gather information.

  3. Make assumptions about future costs. (This is called forecasting.)

  4. Analyze alternatives, and select one.

  5. Implement your decision.

  6. Evaluate the outcome of your decision.

This process may seem obvious, but companies have to learn it. If fact, some companies hire consultants to come onsite to teach the principles.

Say you manufacture Supperware plastic containers — simple items for storing food. You identify a problem: A piece of machinery has become inefficient. The machine breaks down frequently and requires a lot of repair and maintenance. You decide to consider replacing the machine.

Using the decision model, you define a problem. Now gather more information.

Your current machine has a five-year remaining useful life. After that, it will have to be scrapped. You can use the machine for five more years, but there are two problems. First, the repair and maintenance expense is much higher on the current machine compared to a new one. Second, the old machine produces fewer items than a new one. Fewer items produced may mean less revenue.

Now forecast — that is, make assumptions about future costs. If you buy a new machine, you have to borrow funds for the purchase. Like any loan, you need to repay the principal (the amount borrowed) and interest. Those payments are part of the decision.

Analyze alternatives, and select one. You perform an analysis on two scenarios. In the first scenario, everything stays as is. In the second scenario, you buy a new machine. (That also means that you sell the old machine, but it’s not worth much, because the technology is very old.)

You analysis should include a comparison of the most expense and revenue data.

Depreciation is an expense. Depreciation expense accounts for the decline of an asset’s value. The decline occurs as the asset is “used up.” You calculate depreciation expense using the cost of the asset, its useful life, and its salvage value.

Salvage value is the sales proceeds you receive if you choose to sell the asset at the end of its useful life. When you buy a new car, you get cash by trading in your old car. That’s the salvage value. Actually, the dealer uses the trade-in “cash” to reduce the cost of the new vehicle.

Most important, depreciation expense doesn’t use “real” cash — the expense is on your books, but you don’t write a check each year as your car depreciates. The car is just worth less. By the way, there are many ways to calculate depreciation. Some methods have more expense in early years and less in later years. Other methods assume a fixed amount each year. What you see in the table is called five-year straight-line.

Here’s an analysis, comparing “keepin’ on keepin’ on” with the old machine for five years versus buying a new machine.

Machine Purchase Decision — Comparison
Annual Expense Old Machine New Machine
New machine loan payments N/A -$100,000
Proceeds from selling old machine $20,000 $0
Depreciation expense -$30,000 -$50,000
Repair and maintenance expense -$25,000 -$5,000
Subtotal: Annual expense -$35,000 -$155,000
Annual production revenue
Units produced (A) 80,000 130,000
Revenue per unit (B) $2 $2
Annual revenue (A x B) $160,000 $260,000
Revenue less expense $125,000 $105,000

It might be surprising, but you’re better off keeping the old machine for five years. Check out the bottom line of the table. The old machine’s total is $20,000 higher each year ($125,000 versus $105,000).

Sure, you would earn a lot more revenue from the new machine each year. In fact, you could take in $100,000 more ($260,000 versus $160,000). However, you have to pay that $100,000 annual tab for the loan. Because it’s a new machine (and almost certainly more expensive to buy), your depreciation expense is also higher.

To be fair to the new machine, the numbers for the old machine look good only in Year 5, when you take in $20,000 in salvage value. Ignore that, and both deals are even. Further, if production is trending up, the old machine will never keep pace, so you may want to seriously consider buying that new machine.

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