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Relevant Costs and Benefits

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1 Relevant Costs and Benefits
Chapter 11 Decision 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- guard Auto Service Center Differential costs and revenues Monthly salary $1,200 $1,500 $300  Monthly expenses: Commuting 30 90 60  Meals 150 Apartment rent 450 Uniform rental 50 50  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” Decision Essex 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” Decision The special equipment used to manufacture part 4A has no resale value General factory overhead is allocated on the basis of direct labor hours The $30 total unit cost is based on 20,000 parts produced each year An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part Should 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?

10 Special Orders $8 variable cost

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 $1.35 Direct labor Manufacturing overhead   0.80 Unit product cost $2.30 The 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 pencil Total 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 year 1,000,000 units Cost per unit when each purchase is equal to 10,000 units $16.00 Cost per unit when each purchase is equal to or greater than 500,000 units; $16 minus 1% discount $15.84 Cost of a purchase order $500 Alternatives under consideration: A. Make 100 purchases of 10,000 units each during next year B. Make 2 purchases of 500,000 units during the year Average investment in inventory: A. (10,000 units x $16.00 per unit) / 2 a B. (500,000 units x $15.84 per unit / 2 a $80,000 $3,960,000 Annual 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 Fancy Phone Phone Selling price $ $ 120 Variable costs Contribution margin $ $ 36 Contribution-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 available If 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 Fancy Phone Phone 1. Units per hour 2. Contribution margin per unit $ $ 36 Contribution margin per hour Total contribution for 10,000 hours

21 Another Scarce Resource Decision
Power Recreation assembles two engines - a snowmobile engine and a boat engine - at its Lexington, Kentucky, plant. Snowmobile Engine Boat Engine Selling Price $800 $1,000 Variable cost per unit 560 625 Contribution margin per unit $240 $375 Contribution 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 Decision White’s sales are $200,000 per year Fixed expenses, other than depreciation, are $70,000 per year Should 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 Machine New Machine Original Cost $1,000,000 $600,000 Useful Life 5 years 2 years Current age 3 years 0 years Remaining useful life Accumulated Depreciation Not acquired yet Book Value $400,000 Current disposal value (in cash) $40,000 Terminal disposal value (in cash 2 years from now) $0 Annual 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?

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