Presentation on theme: "Relevant Costs and Benefits"— Presentation transcript:
1 Relevant Costs and Benefits Chapter 11Decision making:Relevant Costs and Benefits
2 DIFFERENTIAL COSTS AND REVENUES Differential costs and revenues Bill is currently employed as a lifeguard, but he has been offered a job in an auto service center in the same town. The differential revenues and costs between the two jobs are listed below:Life-guardAutoService CenterDifferential costs and revenuesMonthly salary$1,200$1,500$300 Monthly expenses:Commuting309060 Meals1500 Apartment rent450Uniform rental5050 Union dues 10 0 (10)Total monthly expenses 640 740 100 Net monthly income$ 560$ 760$200
3 Identifying Relevant Costs She has also gathered this additional information to aid in her decision.
4 Total and Differential Cost Approaches The management of a company is considering a new laborsaving machine that rents for $3,000 per year. Data about the company’s annual sales and costs with and without the new machine are:
5 Analysis of Special Decisions Let’s take a look at another decision faced by many businesses.We need a particular component for our manufacturing process. Do you think we should make or buy this particular item?W
6 “Make or Buy” DecisionEssex manufactures part 4A that is currently used in one of its products.The unit cost to make this part is:
7 Should we accept the supplier’s offer? “Make or Buy” DecisionThe special equipment used to manufacture part 4A has no resale valueGeneral factory overhead is allocated on the basis of direct labor hoursThe $30 total unit cost is based on 20,000 parts produced each yearAn outside supplier has offered to provide the 20,000 parts at a cost of $25 per partShould we accept the supplier’s offer?
8 Analysis of Special Pricing Decisions Let’s take a look at another decision faced by many businesses:Another firm has offered to pay us $10 for a product that normally sells for $25. Do you think we should accept this special order?W
9 Special Orders Should Jet accept the offer? Jet, Inc. makes a single product whose normal selling price is $20 per unit.A foreign distributor offers to purchase 3,000 units for $10 per unit.This is a one-time order that would not affect the company’s regular business.Annual capacity is 10,000 units, but Jet, Inc. is currently producing and selling only 5,000 units.Should Jet accept the offer?
11 Accept or Reject a Special Order Jamestown Candleworks has just received a request from the Williamsburg Foundation for 800 candles to be used in a special event for major donors. The candles will be used as the only illumination in the reception room and will be given out as gifts to the donors as they leave. The candles will be imprinted with the Williamsburg Foundation logo. This sale will have no effect on the company’s normal sales to retail outlets. The normal selling price of a candle of about the size and weight of the special candles is $3.95 and its unit product cost is $2.30, as shown below:Direct materials $1.35Direct laborManufacturing overhead 0.80Unit product cost $2.30The variable portion of the manufacturing overhead is $0.05 per candle; the other $0.75 represents fixed manufacturing costs that would not be affected by this special order.
12 Accept or Reject a Special Order (continued) Jamestown Candleworks would have to order a special candle mold in which the Williamsburg Foundation logo is inscribed. Such a mold would cost $800. In addition, the Williamsburg Foundation wants a special wick containing gold-like thread that would add $0.20 to the cost of each candle.Because of the large size of the order and the charitable nature of the work, the Williamsburg Foundation has asked to pay only $2.95 each for this candle.If accepted, what effect would this order have on the company’s net operating income?
13 Accept or Reject a Special Order Your firm has the capacity to produce 10,000 pencils monthly.It’s December 15th. To date your firm has orders for 8,000 pencils. You don’t anticipate getting any more orders until next January.Your cost and revenue information is as follows:Sales price per pencil $Variable cost per pencilTotal fixed costs $28,000
14 Accept or Reject a Special Order Jack Frost,Mayor of Burnville, comes to you and says he would like to give all his staff pencils as Christmas presents, but doesn’t want to pay a lot for them. He offers you $4 per pencil for 2,000 pencils.Should you take this deal?
15 Accept or Reject a Special Order What if, instead, Jack Frost says he will give you $4 per pencil for 4,000 pencils.Should you take this deal?
16 Carrying Costs of Inventory Annual estimated stereo CD player requirements for next year1,000,000 unitsCost per unit when each purchase is equal to 10,000 units$16.00Cost per unit when each purchase is equal to or greater than 500,000 units;$16 minus 1% discount$15.84Cost of a purchase order$500Alternatives under consideration:A. Make 100 purchases of 10,000 units each during next yearB. Make 2 purchases of 500,000 units during the yearAverage investment in inventory:A. (10,000 units x $16.00 per unit) / 2 aB. (500,000 units x $15.84 per unit / 2 a$80,000$3,960,000Annual rate of return if cash is invested elsewhere (for example, bonds or stocks at the same level of risk as investment in inventory)9%a The example assumes that stereo-CD-player purchases will be used uniformly throughout the year. The average investment in inventory during the year is the cost of the inventory when a purchase is received plus the cost of inventory just before the next purchase is delivered (in our example, zero) divided by 2.Soho will pay cash for the stereo CD players it buys. Which purchasing alternative is more economical for Soho?
17 Scarce Resource Constraint A company has two products: a plain cellular phone and a fancier cellular phone with many special features:Plain FancyPhone PhoneSelling price $ $ 120Variable costsContribution margin $ $ 36Contribution-margin ratio % %
18 Scarce Resource Constraint Which product is more profitable?On which should the firm spend its resources?It depends.If sales are restricted by demand for only a limited number of phones, fancy phones are more profitable.
19 Scarce Resource Constraint Suppose annual demand for phones of both types is more than the company can produce in the next year.Only 10,000 hours of capacity are availableIf in one hour plant workers can make either three plain phones or one fancy phone, which phone is more profitable?
20 Scarce Resource Constraint Plain FancyPhone Phone1. Units per hour2. Contribution margin per unit $ $ 36Contribution margin per hourTotal contribution for10,000 hours
21 Another Scarce Resource Decision Power Recreation assembles two engines - a snowmobile engine and a boat engine - at its Lexington, Kentucky, plant.Snowmobile EngineBoat EngineSelling Price$800$1,000Variable cost per unit560625Contribution margin per unit$240$375Contribution margin percentage($240/$800; $375/$1,000)30%37.5%
22 Scarce Resource Decision (cont.) Assume that only 600 machine-hours are available daily for assembling engines. Additional capacity cannot be obtained in the short run. Power Recreation can sell as many engines as it produces. The constraining resource, then, is machine-hours. It takes two machine-hours to produce one snowmobile engine and five machine-hours to produce one boat engine.What product mix should Power Recreation choose to maximize its operating income?
23 Analysis of Equipment Replacement Decisions Let’s take a look at another decision faced by many businesses:Should we replace a machine with a newer and more efficient one?W
24 Equipment Replacement Decision A manager at White Co. wants to replace an old machine with a new, more efficient machine:
25 Should the manager purchase the new machine? Equipment Replacement DecisionWhite’s sales are $200,000 per yearFixed expenses, other than depreciation, are $70,000 per yearShould the manager purchase the new machine?
26 Another Equipment Replacement Decision Toledo Company is considering replacing a metal-cutting machine with a newer model. The new machine is more efficient than the old machine, but it has a shorter life. Revenues from aircraft parts ($1.1 million per year) will be unaffected by the replacement decision. Here’s the data on the existing (old) machine and the replacement (new) machine:
27 Equipment Replacement Decision (cont.) Old MachineNew MachineOriginal Cost$1,000,000$600,000Useful Life5 years2 yearsCurrent age3 years0 yearsRemaining useful lifeAccumulated DepreciationNot acquired yetBook Value$400,000Current disposal value (in cash)$40,000Terminal disposal value (in cash 2 years from now)$0Annual operating costs (maintenance, energy, repairs, coolants, and so on)$800,000$460,000
28 Equipment Replacement Decision (cont.) Toledo Corporation uses straight-line depreciation. To focus on relevance, we ignore time value of money and income taxes.Should Toledo replace its old machine?