Management Is Currently Deciding Whether to Investigate a Cost Variance

question 8

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., it is operating normally).
2. The underlying operation is out of control (and therefore needs 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 = $5,000.
2. Cost of correcting an out-of-control process (if the process is found to be out of control) = C = $10,000.
3. Losses from not correcting an out-of-control process = L = $110,000.
4. Probability, p, of the process being out of control = 60%
Required:
1. Recast the above information in the form of a payoff table.
2. What is the expected cost (to the nearest dollar) of the decision to investigate the variance? Show calculations.
3. What is the expected cost (to the nearest dollar) of the decision to not investigate the variance? Show calculations.
4. What is the break-even probability of the process being out of control, p, which would make management indifferent between investigating and not investigating the observed variance? Demonstrate that, in fact, this is the break-even probability by showing the expected value of each management action. Show calculations.

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Definitions:

Fraud

Wrongful or criminal deception intended to result in financial or personal gain.

Company Assets

Resources owned by a company that have economic value and can be used to meet debts, commitments, or investments.

Personal Gain

The benefit or advantage acquired by an individual from a particular scenario or transaction, often financial in nature.

Internal Control

A process designed to ensure the reliability of financial reporting, effectiveness of operations, and compliance with laws and regulations.