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 0 
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
Han Products manufactures 30,000 units of part S-6 each year for use on its production line. At this level of activity, the cost per unit for part S-6 is as follows:
Direct materials $3.60
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead  
Total cost per part $25.00

7. Make or Buy (continued)
An outside supplier has offered to sell 30,000 units of part S-6 each year to Han Products for $21 per part. If Han Products accepts this offer, the facilities now being used to manufacture part S-6 could be rented to another company at an annual rental of $80,000. However, Han Products has determined that two-thirds of the fixed manufacturing overhead being applied to part S-6 would continue even if part S-6 were purchased from the outside supplier.
Prepare computations showing how much profits will increase or decrease if the outside supplier’s offer is accepted.

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. Accept/Reject Special Orders
Polaski Company manufactures and sells a single product called a Ret. Operating at capacity, the company can produce and sell 30,000 Rets per year. Costs associated with this level of production and sales are given below:
The Rets normally sell for $50 each. Fixed manufacturing overhead is constant at $270,000 per year within the range of 25,000 through 30,000 Rets per year.
Unit
Total
Direct materials
$15
$450,000
Direct labor 8
240,000
Variable manufacturing overhead 3
90,000
Fixed manufacturing overhead 9
270,000
Variable selling expense 4
120,000
Fixed selling expense 6
180,000
Total cost
$45
$1,350,000

10. Accept/Reject Special Orders (continued)
Assume that due to a recession, Polaski Company expects to sell only 25,000 Rets through regular channels next year. A large retail chain has offered to purchase 5,000 Rets if Polaski is willing to accept a 16% discount off the regular price. There would be no sales commissions on this order; thus, variable selling expenses would be slashed by 75%.
However, Polaski Company would have to purchase a special machine to engrave the retail chain’s name on the 5,000 units. This machine would cost $10,000. Polaski Company has no assurance that the retail chain will purchase additional units in the future. Determine the impact on profits next year if this special order is accepted.

11. Accept/Reject Special Orders (continued)
Refer to the original data. Assume again that Polaski Company expects to sell only 25,000 Rets through regular channels next year. The U.S. Army would like to make a one-time-only purchase of 5,000 Rets. The Army would pay a fixed fee of $1.80 per Ret, and it would reimburse Polaski Company for all costs of production (variable and fixed) associated with the units. Because the army would pick up the Rets with its own trucks, there would be no variable selling expenses associated with this order.
If Polaski Company accepts the order, by how much will profits increase or decrease for the year?

12. Accept/Reject Special Orders (continued)
Assume the same situation as that described in the previous slide, except that the company expects to sell 30,000 Rets through the regular channels next year. Thus, accepting the U.S. Army’s order would require giving up regular sales of 5,000 Rets.
If the Army’s order is accepted, by how much will profits increase or decrease from what they would be if the 5,000 Rets were sold through regular channels?

13. 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?

14. 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 % %

15. 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.

16. 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?

17. 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

18. 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%

19. 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?

20. 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

21. Equipment Replacement Decision
A manager at White Co. wants to replace an old machine with a new, more efficient machine:

22. 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?

23. 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:

24. 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

25. 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?