Explore BrainMass
Share

Relevant Costs for Decision Making

This content was STOLEN from BrainMass.com - View the original, and get the already-completed solution here!

An Illustration of Relevant Costs for Decision-Making

ABSTRACT
The concepts of incremental cost, opportunity cost, sunk cost, and cost allocation are identified and discussed in the context of early U.S. foreign policy. The case is derived from an authentic exchange of views between Thomas Jefferson and John Adams on how the United States should protect its merchant shipping against the Barbary Pirates. Both men compare the cost of waging war against the pirates with the cost of paying ransom for captured U.S. seamen and bribes to protect future shipping. Adams quantifies the opportunity cost associated with not taking any action against the pirates. Jefferson articulates an incremental costing argument, on the assumption that the U.S. should build a navy regardless of U.S. policy towards the Barbary States. The case constitutes a brief introduction to management accounting by illustrating different cost concepts, and also lends itself to a discussion of the historical origins of management accounting.

The beginning of wisdom in using accounting for decision-making is a clear understanding that the relevant costs and revenues are those which as between the alternatives being considered are expected to be different in the future. It has taken accountants a long time to grasp this essential point.
R. H. Parker (1969, 15)

BACKGROUND
The Barbary Pirates
Throughout the 17th and 18th centuries, the North African Barbary States of Morocco, Algiers, Tunis and Tripoli engaged in piracy of European merchant shipping. The Barbary pirates routinely captured and confiscated ships and cargo, and enslaved or ransomed their crews and passengers. England, France and Spain entered into treaties with the Barbary States, in effect, paying "protection money" for their merchant shipping. These powerful European nations preferred bribery to war, because they perceived an economic benefit from the threat the pirates posed to the merchant shipping of other European nations.
Until the Revolutionary War, merchant ships from the American Colonies were protected by the British Royal Navy and by the treaties between England and the Barbary States. American shipping lost this protection in 1783, and within the next two years three American ships were captured, one by Morocco and two by Algiers. Morocco soon freed the American crew in exchange for a ransom of 5,000 pounds sterling (about $25,000).1 The crews held by the Algerians were captive throughout 1786 and for some time thereafter.

Historical Background
The capture of American ships by the Barbary pirates created an early and important foreign policy crisis for the United States. The U.S. response to the Barbary crisis was strongly influenced by two factors, one military and the other financial. The military consideration was that the U.S. had no navy. The Continental Navy of the Revolutionary War was disbanded in 1784, and the navy was not reestablished until 1798. During the intervening years, the United States had minimal naval power. Disbanding the Continental Navy was primarily a cost-savings measure. However, there were also important non-financial arguments for and against the navy. Some Americans who favored reestablishing close ties with England feared that the presence of a U.S. navy on the high seas would lead to confrontations with the British Navy. Other Americans, including John Adams, viewed a strong navy as the best national defense against foreign threats. Many Americans preferred the prospect of building a navy over an army due to their general distrust of standing armies?the result of their experience with the British occupation in America during the latter part of the Colonial Era.
The financial factor that influenced the U.S. response to the Barbary pirates was that any effective response would require a significant expense relative to the government's available funds. The U.S. government found itself in a precarious financial condition in the years immediately following the Revolutionary War. The Continental Congress and individual states borrowed over $40 million to finance the war, including about $6 million from France. From 1781 to 1788, the period during which the United States operated under the Articles of Confederation, the federal government did not have the power to tax its citizens, levy tariffs, or regulate commerce. The cost of operating the government during this time was about $500,000 annually, not including funding the debt (Hicks et al. 1970, 103). Some income was generated by the post office and from sales of public lands, but the two principal revenue sources available to the government were requesting support from the states and issuing paper money. State contributions to the federal government constituted only a small fraction of what was needed, and issuing paper money was an inflationary measure that had already been used extensively during the Revolutionary War. The financial plight of the new nation was sufficiently acute that during this period, the government borrowed from foreign sources just to meet the interest obligations on existing foreign debt.
The ratification of the Constitution in 1788 greatly enhanced the powers of the Federal government, and allowed the new Congress to levy and collect duties and taxes. However, the ability of the new government to actually enact and enforce revenue-generating measures was untested, and evolved over time. In 1786, during the Confederation period, and again in 1794, during Washington's presidency, popular opposition to taxation led to civil unrest. The first incident, Shays' Rebellion, arose in Massachusetts when the State Legislature levied taxes to pay off the war debt. The second incident, the Whiskey Rebellion, occurred in Western Pennsylvania when the federal government imposed an excise tax on distilled liquor. Also, although the Federal government had more potential resources under the Constitution than under the Articles of Confederation, it soon had more obligations. In 1790, under a plan advanced by Secretary of the Treasury Alexander Hamilton, the federal government assumed the remaining war debts that were owed by the individual states.
However, despite financial tribulations at both the state and federal levels, economic conditions in the United States during this period were generally good. A short recession that occurred after the Revolutionary War was followed by a period of economic growth. The strong economy led to increased federal revenues, and that fact, combined with the success of American leaders in keeping the nation out of the growing conflict between England and France, enabled the government to become current on its obligations under the national debt during Jefferson's administration.

The Adams-Jefferson Correspondence
In 1786, John Adams was the leading U.S. diplomat in London, and Thomas Jefferson was the U.S. ambassador to France. A few years earlier, in 1784, the Continental Congress had authorized Adams and Jefferson to negotiate treaties with the Barbary States (Kitzen 1993, 10). Consequently, the responsibility to negotiate the release of the captured American seamen, and to establish U.S. foreign policy that would protect U.S. shipping in the Mediterranean, fell largely to these two men. Against this backdrop, Adams sent Jefferson a letter that included the following analysis:

Adams to Jefferson
Grosvenor Square, June 6, 1786

Dear Sir

... The first Question is, what will it cost us to make Peace with all five [Barbary States]? Set it if you will at five hundred Thousand Pounds Sterling, tho I doubt not it might be done for Three or perhaps for two.
The Second Question is, what Damage shall we suffer, if we do not treat.
Compute Six or Eight Per Cent Insurance upon all your Exports, and Imports.
Compute the total Loss of all the Mediterranean and Levant Trade.
Compute the Loss of half your Trade to Portugal and Spain.
These computations will amount to more than half a Million sterling a year.
The third Question is what will it cost to fight them? I answer, at least half a Million sterling a year without protecting your Trade, and when you leave off fighting you must pay as much Money as it would cost you now for Peace.
The Interest of half a Million Sterling is, even at Six Per Cent, Thirty Thousand Guineas a year. For an Annual Interest of 30,000 pounds sterling then and perhaps for 15,000 or 10,000, we can have Peace, when a War would sink us annually ten times as much. (Cappon 1959, 133-134)

In the last paragraph of the excerpt, Adams states interest expense in terms of guineas. A guinea was worth about one pound sterling. Jefferson responded to Adams a few weeks later:
Jefferson to Adams
Paris, July 11, 1786I need some help with the questions at the end of the case study.

(See attached file for full problem description)

© BrainMass Inc. brainmass.com October 24, 2018, 6:51 pm ad1c9bdddf
https://brainmass.com/business/business-policy-and-implementation/relevant-costs-for-decision-making-50637

Attachments

Solution Preview

John Adams, Thomas Jefferson, and the Barbary Pirates:

An Illustration of Relevant Costs for Decision-Making

Dennis Caplan
Iowa State University

Most Recent Update: August 7, 2002

John Adams, Thomas Jefferson, and the Barbary Pirates:

An Illustration of Relevant Costs for Decision-Making

ABSTRACT
The concepts of incremental cost, opportunity cost, sunk cost, and cost allocation are identified and discussed in the context of early U.S. foreign policy. The case is derived from an authentic exchange of views between Thomas Jefferson and John Adams on how the United States should protect its merchant shipping against the Barbary Pirates. Both men compare the cost of waging war against the pirates with the cost of paying ransom for captured U.S. seamen and bribes to protect future shipping. Adams quantifies the opportunity cost associated with not taking any action against the pirates. Jefferson articulates an incremental costing argument, on the assumption that the U.S. should build a navy regardless of U.S. policy towards the Barbary States. The case constitutes a brief introduction to management accounting by illustrating different cost concepts, and also lends itself to a discussion of the historical origins of management accounting.

The beginning of wisdom in using accounting for decision-making is a clear understanding that the relevant costs and revenues are those which as between the alternatives being considered are expected to be different in the future. It has taken accountants a long time to grasp this essential point.
R. H. Parker (1969, 15)

BACKGROUND
The Barbary Pirates
Throughout the 17th and 18th centuries, the North African Barbary States of Morocco, Algiers, Tunis and Tripoli engaged in piracy of European merchant shipping. The Barbary pirates routinely captured and confiscated ships and cargo, and enslaved or ransomed their crews and passengers. England, France and Spain entered into treaties with the Barbary States, in effect, paying "protection money" for their merchant shipping. These powerful European nations preferred bribery to war, because they perceived an economic benefit from the threat the pirates posed to the merchant shipping of other European nations.
Until the Revolutionary War, merchant ships from the American Colonies were protected by the British Royal Navy and by the treaties between England and the Barbary States. American shipping lost this protection in 1783, and within the next two years three American ships were captured, one by Morocco and two by Algiers. Morocco soon freed the American crew in exchange for a ransom of 5,000 pounds sterling (about $25,000).1 The crews held by the Algerians were captive throughout 1786 and for some time thereafter.

Historical Background
The capture of American ships by the Barbary pirates created an early and important foreign policy crisis for the United States. The U.S. response to the Barbary crisis was strongly influenced by two factors, one military and the other financial. The military consideration was that the U.S. had no navy. The Continental Navy of the Revolutionary War was disbanded in 1784, and the navy was not reestablished until 1798. During the intervening years, the United States had minimal naval power. Disbanding the Continental Navy was primarily a cost-savings measure. However, there were also important non-financial arguments for and against the navy. Some Americans who favored reestablishing close ties with England feared that the presence of a U.S. navy on the high seas would lead to confrontations with the British Navy. Other Americans, including John Adams, viewed a strong navy as the best national defense against foreign threats. Many Americans preferred the prospect of building a navy over an army due to their general distrust of standing armies?the result of their experience with the British occupation in America during the latter part of the Colonial Era.
The financial factor that influenced the U.S. response to the Barbary pirates was that any effective response would require a significant expense relative to the government's available funds. The U.S. government found itself in a precarious financial condition in the years immediately following the Revolutionary War. The Continental Congress and individual states borrowed over $40 million to finance the war, including about $6 million from France. From 1781 to 1788, the period during which the United States operated under the Articles of Confederation, the federal government did not have the power to tax its citizens, levy tariffs, ...

Solution Summary

This explains the concept of Relevant Costs for Decision Making with the help of a case study

$2.19
See Also This Related BrainMass Solution

ABC; Cost behavior; Decision making and relevant information

By the end of its second year of operations, First General Associates (FGA) had accumulated the following data. FGA delivers certain services to various organizations on a cost - plus basis. Service delivery involves considerable labor and materials as well as significant equipment usage. As a basis to estimate cost behavior for different activity bases, the CFO of FGA has asked you to analyze the data in the table below and provide your estimates for the items following the table.

Total costs incurred for 2 years Cost behavior
Note: all costs are paid monthly Equipment Hours Service Delivery Units
Cost category Amount
Materials $503,000
Service delivery labor 4,997,000
Supervisory and support salaries and wages 630,000
Lease 298,000
Utilities (heat and air conditioning) 206,000
Electrical Power to run equipment 104,000
Equipment Maintenance 224,000
Equipment Depreciation 72,000
Research and Development 171,000
Total costs $7,205,,000
Units of service delivered 202,500
Equipment hours 1,022,700
Service delivery labor hours 815,800

Required

1. For each cost category above, determine whether the cost is fixed (F), semi-variable (M) or variable (V) with respect to each level of activity shown above - Equipment Hours and Service Delivery Units - and place an F, M or V in the appropriate column.

2. Based on your determination of cost behavior in part 1, what is your best estimate for each of the following:

Annual total costs

Average monthly fixed costs:

Variable cost per unit of service delivered:

Total cost per unit of service delivered:
3. What additional data would you need to make a better determination of cost behavior for FGA? Be specific and cite illustrations of how you would determine cost behavior using the criteria in Chapter 10 of the text.

4. In this situation, is the total cost per unit of service delivered affected by your determination of cost behavior?

If not, what is the value of separating costs for service delivery into fixed and variable or semi-variable components?

5. In each case in the table below, would FGA recover all its costs in the next year if the prices charged to organizations of each service unit delivered was at least equal to the total cost per unit of service delivered you calculated in part 2? (In making your determination, compare the estimated total costs below with the annual costs incurred determined in Part 2 above.)

Service units Fixed costs Variable costs Total costs Total Revenues
A.100,000
B 105,000
C 110,000

Case A:

Case B:

Case C:

Problem 5-1
Fairfax Treatment Agency

Part A

The Fairfax Treatment Agency delivers the following program services:
• Alcoholic rehabilitation
• Drug-addict treatment
• Basic health care services, and
• Counseling and suicide prevention

The Agency's FY 200X staffing and operating data are as follows:

Professional salaries:
6 physicians  $100,000 $600,000
19 psychologists  $50,000 950,000
23 treatment technicians  $25,000 575,000 $2,125,000
Medical supplies 300,000
Administrative salaries, rent, utilities, and related costs 1,275,000
Total $3,700,000

The agency director needs to know the cost of each program as a basis for planning and budgeting decisions. She specifically needs to decide on whether to provide funds to alcoholic rehabilitation or drug-addict treatment. She has determined that if the cost to treat a drug-addict patient for a year is more than 15% higher than the cost to treat an alcoholic rehabilitation patient for a year, the alcohol program would receive additional funds. Otherwise the drug-addict program would receive additional funds.

Personnel assigned to individual programs are as follows:

Alcohol Drug - Basic
Rehab Addict Health Counseling Total
Physicians 2 4 6
Psychologists 6 4 9 19
Technicians 4 6 4 9 23

Costs of medical supplies are allocated to programs on the basis of physician-hours spent in each program. Administrative costs are allocated on the basis of direct labor cost of each program (i.e., the total cost of professional salaries for each program).

Eighty patients are in residence in the alcohol rehabilitation program, each staying about six months, equating to 40 patient-years of service delivery in the drug and alcohol program. 100 patients are involved in the drug addict program for about six months each, equating to 50 patient-years of service delivery in the drug program.

Required: Based on the information provided:

1. Complete the following table to determine the cost of each program and the cost per patient-year of the alcohol rehabilitation and drug-addict treatment programs.

Cost Item Alcohol Rehab Drug Addict Treatment Basic Health Counseling Total Cost
Salaries

$2,125,000
Medical supplies

300,000
Administrative Costs

1,275,000
Total Costs $3,700,000
Patient years 40 50
Cost/patient year

2. Based on your analysis, should the director provide additional funds to the drug program or to the alcohol program?

3. What factors, other than cost, do you think the Fairfax Treatment Agency should consider in providing resources to its programs?

Problem 11-1
Safe Center Program

An organization operates a "safe center" program for youthful offenders (e.g., those arrested for minor drug violations and runaways). These safe centers provide food, temporary lodging, and counseling assistance. While at the centers, youths meet with trained counselors to address their problems.

Each center has a rated capacity to serve 40 youths. The average stay is two months. Therefore, each center serves approximately 240 youths annually (i.e., 40 rooms each occupied by 6 different youths over the course of a year). There are currently twenty centers in operation. Since the program began operations, each of the centers has always been filled to its rated capacity of 40.

Due to increased demand, the program director has asked you to investigate ways to increase the number of youths served. She prefers to increase the number of centers. However, another alternative is to increase the rated capacity at each center from 40 to the maximum capacity of 50.

The annual cost of operating the entire program is $5,240,000 or $262,000 per center. The cost per youth served at each center is, on average, $6,550 a year or $1,092 for a two month stay.

A detailed analysis of annual costs for operating a center at its rated capacity of 40 is as follows:

Rent $12,000
Director 48,000
Counselors (2@ $30,000) (note 1) 60,000
Furniture/Fixtures (note 2) 6,000
Food Service ($2,400 per youth) 96,000
Hotelling support ($375 per youth) 15,000
Medical support ($400 per youth) 16,000
Central Office Costs (note 3) _ 9,000
Total Costs Per Center $262,000

Note 1: A counselor must be hired full-time and can handle a maximum of 20 youths at any one time.

Note 2: This cost is annual depreciation of furniture and fixtures with useful life of four years. The furniture will have to be replaced in about two years at a cost of $24,000.

Note 3: Central office costs of $180,000 are divided equally among the twenty centers. Of these costs, $120,000 are fixed: $60,000 is variable ($3,000 per center).

Required

1. Specify the annual costs of increasing capacity of each existing center by ten places per center to its maximum capacity.

2. Specify the costs of adding 200 places at an additional five centers (rated capacity of 40). Consider only the costs of the first year to simplify the analysis.

3. Why might you not recommend the option with the lower cost?

4. Suppose that resource constraints forced the reduction of the scope of the program by a budget reduction of 15 percent or $786,000. How would you recommend the cuts be made:

A: by reducing the number of centers, or

B: by reducing the number of places at each center?

Consider only savings for the first year. Explain and indicate any factors for which information is not provided that you would want to take into consideration.

View Full Posting Details