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ADMS 1500 8.docx

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Administrative Studies
ADMS 1500
Paul Evans

Chapter 8 - Differential cost and revenues vs. Sunk costs - The role of capacity - How to decide whether to make or buy - The difference between a short-term and a long-term decision Relevant Information Information is relevant to a decision problem when . . . - It has bearing on the future - It differs among competing alternatives Identifying Relevant Costs and Benefits Revenues are typically variable (they rise or fall in proportion to output). A simple approach to cost behaviour is that any cost may be classified as either: • Variable (rises or falls in proportion to output); or • Fixed (it is not affected by output). This is closely related to the idea of differential costs and revenues: a differential cost or revenue is one that occurs as a result of a decision. Some fixed cost could be relevant (i.e. outsourcing) Identifying Relevant Costs and Benefits Sunk costs: Costs that have already been incurred. They do not affect any future cost and cannot be changed by any current or future action. Sunk costs are irrelevant to decisions Relevant or Sunk Costs Full costs $2.25 Proposed selling price $2 Is the new customer offer worthwhile? Calculate the variable costs and contribution margin Decision rule: YES if CMg > 0 Accept or reject a special offer - A travel agency offers Worldwide Airways $150,000 for a round-trip flight from Hawaii to Japan on a jumbo jet. - Worldwide usually gets $250,000 in passengers revenue from this flight. - The airline is not currently planning to add any new routes and has two planes that are idle and could be used to meet the needs of the agency. - The next screen shows cost data developed by managerial accountants at Worldwide. - PROFIT: $90,000 - Yes they should take reservation Selling price for charter $ 150,000 Variable cost per flight $ 90,000 Reservation cost savings (5,000) Variable cost of charter 85,000 Contribution from charter $ 65,000 Since the charter will contribute to fixed costs and Worldwide has idle capacity, the company should accept the flight. Company will lose money. What if Worldwide has no excess capacity? If Worldwide adds the charter, it will have to cut its least profitable route that currently contributes $80,000 to fixed costs and profits. Should Worldwide still accept the charter? Special price for charter $ 150,000 Variable cost per flight $ 90,000 Reservation cost savings (5,000) Opportunity cost:charter 85,000 Lost contribution on route 80,000 165,000 Total Contribution from Charter $ (15,000) Worldwide has no
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