Management Is Currently Deciding Whether to Investigate a Cost Variance

Essay

Management is currently deciding whether to investigate a cost variance that was identified by the accounting system. To help address this question, you have generated the following data:
Possible States of Nature:
1. The underlying operation is in control (i.e., is operating normally).
2. The underlying operation is out of control (and therefore is in need of an intervention)
Possible Decisions/Courses of Action:
1. Investigate the variance (to determine its underlying cause(s)).
2. Do not investigate the variance.
Estimated Costs and Probabilities:
1. Cost of investigating the variance = I = $1,500.
2. Cost of correcting an out-of-control process (if the process is found to be out of control) = C = $6,000.
3. Losses from not correcting an out-of-control process = L = $50,000.
4. Probability, p, of the process being out of control = 15%
Required:
1. Given the above information, what is the expected value of investigating the reported variance? (Show calculation, and round answer to nearest whole dollar.)
2. Prepare a payoff table that summarizes the states of nature (i.e., possible outcomes) and the decision alternatives (i.e., management actions). Your table should include cells for combinations of management actions and states of nature, plus cells to represent the expected value of each management action. Which decision is recommended based on information in your payoff table?
3. Given the above information, what is the probability level, p, for an out-of-control process (i.e., a nonrandom variance) that would make management indifferent between investigating and not investigating the variance? Round your answer to four (4) decimal places, e.g., 0.0456134 = 0.0456.
a. In what sense can this probability be considered a breakeven probability? (Demonstrate this by calculating the expected value of each management action, based on the break-even probability, p, you calculated.) Round final answers to the nearest whole numbers.
b. What is the correct management action if the probability of an out-of-control process is greater than the break-even probability, p? Show all calculations.