2 Relevant Information for Special Decisions Chapter 5Relevant Information forSpecial Decisions
3 Relevant InformationTwo primary characteristics distinguish relevant from useless information:Relevant information differs among the alternatives under consideration.Relevant information is future oriented.We can identify relevant information by looking at two characteristics; first relevant information differs among the alternatives being considered by the manager and second relevant information is future oriented that he is it involves amounts that will impact future operations. A great deal of information that may appear to be relevant at first blush may in fact not meet both of the characteristics we’ve just discussed. When information fails to meet these two conditions it is irrelevant to the decision process and must be ignored.
4 Relevant (Differential) Revenues Relevant revenues must (1) be future oriented and (2) differ for the alternatives under consideration. Since relevant revenues differ between the alternative, they are sometimes called differential revenues.Like relevant costs them relevant revenues must be future oriented and differ between the alternatives under consideration. Relevant revenues are sometimes referred to as differential revenues.
5 RELEVANT INFORMATIONPass Fast, Inc. is considering two alternative locations in which to conduct its CPA review course. One alternative is an exclusive hotel; the other is a moderately priced training facility. The hotel is in a central location easily accessible to potential students. The training facility is in a less desirable location. Pass Fast has gathered the following cost data regarding the two locations.
6 Rental Fee for Classroom $2,000$1,500Twenty Advertising Brochures Distributed to each Student for Referrals250Cost of Instruction5,000Books (per student)100Refreshments (per student)54Depreciation on Instructional Equipment400
7 Sunk CostA sunk cost has been incurred in the a past transaction and cannot be changed, they are not relevant for making current decisions.Part IA sunk cost is one that has been incurred in the past and cannot be changed regardless of the events we currently face. Sometimes individuals have all motional attachments to some costs that color the decision process.Part IIHere is a perfect example of a sunk costs a person has purchased some stock paying $25,000 cash. The stock has dropped in value to $15,000. the individual really needs a new car but doesn’t have enough cash to purchase one. His coworker suggests he sell the stock for $15,000 and buy the car.
8 Relevancy of Opportunity Costs The sacrifice represented by a lost opportunity is an opportunity cost.Opportunity costs that are (1) future oriented and (2) differ between the alternatives are relevant for decision making, but are extremely difficult to measure.Let’s look at an example.An opportunity cost may be thought of as the sacrifice made by choosing one alternative over one another. Like and other relevant costs opportunity costs are future oriented and must give for between the alternatives being considered. The problem with opportunity costs is that they are extremely difficult to measure.
9 Opportunity CostYou purchased a ticket to the Texas Tech – UT game this fall for $80.Outside the game someone offers you $150.You really want to go to the game and don’t sell your ticketHow much did it cost you to go to the game?$150 is your opportunity cost$80 is your sunk cost
10 ExampleBrown Manufacturing Company is currently using a building as a manufacturing facility. Depreciation on the building is $200,000 per year. The building is in a location that is experiencing significant growth in retail shopping. A retail company has offered to rent the manufacturing facility from BMC at a price of $180,000 per year.What information is relevant in deciding whether to move the manufacturing facility to a different location?
11 Relevant (Avoidable) Costs Unit-level ActivitiesAvoided by eliminating one unit of product.Batch-level ActivitiesAvoided when a batch of work is eliminated.Product-level ActivitiesAvoided if a product line is eliminated.In this chapter we will discuss relevant costs as falling into one of four categories. The first category is known as unit level activities. These are costs that can be avoided by eliminating just one unit of product. Batch level costs can be avoided when entire batch of work is eliminated. Product level costs can be avoided if we eliminate a product line. Facility level costs are more difficult to avoid but some of these costs may be avoided if a product line is eliminated.Facility-level ActivitiesSome costs may be avoided if a product line is eliminated.
12 Cost Classification Hierarchy Unit-level CostsIncurred each time a company generates one unit of productExample: Direct materials & direct labor costsBatch-level CostsCosts incurred for a batch of productsExample: Setup and inspection costsProduct-level CostsCosts incurred to create, sustain, or sell a product or product lineExample: Engineering costs for new automobile modelFacility-level CostsIncurred to support the entire companyExample: Factory depreciation; maintenance; utilities
13 Four Types of Special Decisions Special OrderOutsourcingSegment EliminationAsset Replacement
14 Relevant Information and Special Decisions Occasionally, a company receives an offer to sell its product at a price significantly below its normal selling price. The company must make a special order decision to accept or reject the offer.From time to time companies received a one time special order and must make a decision to accept or reject the offer.
15 Here is budgeted cost information for Premier, a company that produces printers. The company has enough capacity to produce additional printers, but is planning to produce to meet current demand.Here is current budgeted production information for Premier Company. The company manufactures printers with a unit cost of each printer of $ you can see it that the company has broken down its production costs into unit-level. Batch-level product-level and facility-level costs. Premier has excess capacity and is able to produce more than 2000 printers.Cost per unit - $658,500 ÷ 2000 = $329.25
16 Special Order Decision A foreign customer offers to purchase 200 printers at $250 per printer. This price is well below the unit cost of $ Should the company accept this one time order?If the order is accepted, income will increase by $11,800.Part IA foreign customer offered to purchase 200 printers at $250 per printer. The offer price is substantially below the unit product cost. If you were the manager of Premier, would you accept this one time off for?Part IIThe differential revenue is $50, 000, that he is 200 printers times $250 per printer. If we reject the offer we could avoid $180 per printer of unit level costs for a total of $36,000. We could also avoid one setup at $1700 and material handling of $500. The special onetime offer would contribute $11,800 to income, so we should accept the offer.
17 Special Order Decision If Premier can increase income by selling its printer for $250, can the company reduce its normal selling price to $250?Part I if the one-time special offer proved profitable, could premiere of four to sell all of its printers at $250 each?Part II as you can see from our analysis premiere would lose $146,700 if it priced all of its 2200 printers at $250 each. Therefore the company could not afford to sell its printers at $250 each.
18 Special Order Decision Quantitative Aspect1. Determine the amount of revenue the company will earn if it accepts the special order2. Determine the relevant costs of making the additional units3. Compare the incremental revenues to the additional costs
19 What costs must be considered? Unit-level costsRelevant b/c cost will differ if the company makes and sells the units vs. rejecting the special orderBatch-level costsMay or may not be relevantRelevant if must produce a separate batch to fill the orderProduct-level and Facility-level costs remain unchanged = Not Relevant
20 Outsourcing Decisions Companies can sometimes purchase products needed in the manufacturing process for less than it would cost to make them. Buying goods and services from other companies rather than producing them internally is commonly called outsourcing.That test was so easy. How did you score so low?I outsourced my homework!!Part ISometimes companies can purchase products needed in the manufacturing process at a lower cost than the cost to manufacture the product themselves. Purchasing from an outside supplier is referred to as outsourcing. Before we can successfully outsource we have to be issue word that the quality of the product is the same as the quality of the product we manufacture and that delivery will be on a timely basis. If we are not very careful outsourcing may create more problems than its solves.Part II here we have one student asking another why they did so poorly on the exam. The second student answers by saying that she outsourced her homework. As you have learned in this course doing your homework is an important part of preparing yourself for examinations.
21 Outsourcing Decisions Let’s return to our Premier example. Recall that the unit cost per printer was $ A supplier offers to sell an unlimited number of printers to Premier for $240 each. Should Premier accept this outsourcing offer?Step 1 Determine the production costs Premier can avoid if it elects to outsource printer production.Part I and outside supplier offers to sell an unlimited number of printers to Premier for $240 each. Remembered that the unit product costs to Premier was $ Do you think this is a good idea for Premier?Part II the first step is for Premier to determine the production costs that can be avoided if it elects to outsource the printers. As you can see the company can avoid its unit level that’s level and product level costs for a total of $459,300.Part III On a per-unit basis the costs avoided amount to $ Let’s move on to the second step in the decision process.Cost per unit = $459,300 ÷ 2,000 = $229.65
22 Outsourcing Decisions Step 2 Compare the avoidable production costs with the cost of buying the product and select the lower-cost option.COST TO BUY:$240 * 2,200 = $528,000COST TO MAKE:$459,300In the second step we need to compare it be a boy double production costs with the cost of buying the product from the outside supplier. We should select the lower-cost option. As you can see on the schedule there’s the $10.35 cost in favor of manufacture as opposed to outsourcing. If we outsource profits are likely to decline by $20,700. Given these facts Premier should reject the outsourcing offer.Premier should reject the outsourcing offer.
23 Outsourcing Decisions Must identify the relevant costs of making a product internally and compare with cost to buy the product from an outside supplierMake or buy decisionRelevant Costs:Unit-level costsBatch-level costsProduct-level costsFacility-level costs = Not relevant
24 Segment Elimination Decisions Businesses are frequently organized into operating units known as segments. Segment reports can be prepared for products, services, departments, branches, centers, offices, or divisions. These reports normally show segment revenues and costs. Let’s look at an a segment report for Premier Office Products that has divided its operations into three segments; (1) copiers, (2) computers, and (3) printers.Most medium-size and large companies are organized into business units that may be referred to as segments. The segment can be a product line or a department or a division or even a branch office. Let’s assume that premier office products is divided into three segments. The first segment sells copiers, the second segment sells computers, and the third segment sells printers. The management at premier is faced with the situation where one of the segments is operating at a loss. The question is should that segment be eliminated.
25 Should management eliminate the Copier segment? Here is detailed information about the three segments and then the whole role for the company noticed that we’ve arranged the information with our revenues and then our unit-level batch-level product-level and facility-level costs as well as are allocated corporate level costs. The allocation of corporate level costs is more or less arbitrary. The copier division is operating at a loss while the other two segments are reporting income. Should we eliminate the copier division?Should management eliminate the Copier segment?
26 Segment Elimination Decisions A three part decision:Determine the amount of relevant revenue that pertains to eliminating the segment.Determine the amount of cost that can be avoided if the segment is eliminated.If the relevant revenue is less than the avoidable cost, eliminate the segment. If not, continue to operate it.The decision to a limit may a business segment can be divided into three parts. In the first part we determine the amount of relevant revenue that pertains to a limit mating the segment. In the second part we do the same for costs. In the third part if the relevant revenues are less than the avoidable costs we eliminate the segment. If this is not the case we continue to operate the segment even though it shows a loss.
27 Segment Elimination Decisions Step 1: If Premier eliminates the copier segment, it will lose the $550,000 of revenue currently produced. If the segment continues, the revenue will be earned. Since the revenue differs between the alternatives, it is relevant.In the first step we know that if the copier segment is eliminated the company will lose $550,000 in revenue.
28 Segment Elimination Decisions Step 2: If Premier eliminates copiers, it will avoid the following costs:In the second step we determine the cloths that will be eliminated if the copier segment is discontinued. Notice that the allocated corporate level costs are not avoidable but will merely be allocated to the remaining business segments.
29 Segment Elimination Decisions Step 2: If Premier eliminates copiers, its profits will decrease:If at halfwe eliminate the copier segment overall profits will decrease by $62,000. Remember that the corporate level facilities sustaining costs will not be a look eliminated but will be allocated to the remaining two business segments.The corporate-level facility-sustaining costs will not be eliminated, but will be allocated to the remaining segments.
30 Assuming we eliminate the copier segment and allocate the corporate-level costs to the remaining two divisions equally, the company’s income statement will look like this.On this screen we have assumed that the copier segment has in fact been eliminated. Notice that the profits for the computer segment and the printer segment had both decreased an overall company profits had decreased by $62,000.
31 Segment Elimination Decisions Identify relevant costs of operating a business segment and compare with cost to revenue generated by the segmentChoice: Close-down or Continue SegmentRelevant Costs:Unit-level costsBatch-level costsProduct-level costsFacility-level costsSome Corporate-level facility costs may not be relevant
32 Relationships Between Avoidable Costs and Business Activity Special order decisions affect unit-level and possibly batch-level costs.Outsourcing can avoid many product-level as well as unit- and batch-level costs.Segment elimination can avoid some of the facility-level costs.The more complex the decision level, the more opportunities there are to avoid costs.
33 Equipment Replacement Decision The equipment replacement decision should be based on profitability rather than physical deterioration. Consider the following:
34 Equipment Replacement Decision The original cost, current book value, accumulated depreciation, and annual depreciation expense are measures of cost of the old machine relating to prior periods. They are irrelevant because they are sunk costs.The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement decision.The salvage value of the old machine reduces the opportunity cost. The opportunity cost of using the old machine for five more years is $12,000 ($14,000 – $2,000).The $45,000 operating expenses of using the old machine can be avoided if it is replaced, to it is a relevant cost.
35 Equipment Replacement Decision The cost of the new machine can be avoided by keeping the old machine, so it is a relevant cost.The relevant cost of purchasing the new machine is $25,000 ($29,000 – $4,000).The $22,500 of operating expenses can be avoided by keeping the old machine, so the operating expenses are relevant costs.Let’s summarize the relevant costs for the two machines.
36 Equipment Replacement Decision Our analysis should that Premier should acquire the new machine. Over a five-year period the company will save a total of $9,500 ($57,000 – $47,500)
37 Asset Replacement Decisions Identify relevant costs of operating existing assets and compare with costs of operating new, replacement assetsCompany should choose the lowest cost option