1. 1 MANAGERIAL ACCOUNTING & COSTING WEEK 8: LECTURE 8

2. 2 Learning Objectives Identifying Relevant Costs and Benefits for decision making Adding/Dropping decisions for segments within a company The ‘make’ or ‘buy’ decision

3. 3 Relevant Costs for Decision Making Making Decisions is one of the basic functions of a manager. But this is a difficult and complicated task because of the existence of many alternatives and massive amounts of data. However only some of the data may be relevant. Every decision involves choosing between at least two alternatives, and the benefits and costs of each alternative must be compared with those of the other. A relevant cost is a cost that differs between alternatives. 1 2

4. 4 Distinguishing between relevant and irrelevant costs and benefits is critical for two reasons : 1. Irrelevant data can be ignored and not analyzed. This can save important time and effort. 2. Bad decisions can easily result from wrongly including irrelevant costs and benefit data when analyzing alternatives. To be successful in decision making managers must be able to recognize the difference between relevant and irrelevant data and must be able to use correctly the relevant data when analyzing alternatives.

5. 5 FIRST RECALL 3 COST CONCEPTS 1.Opportunity cost is the potential benefit that is given up when one alternative is selected over another. Example 1: Vicki has a part-time job that pays her €500 per week while attending college. She would like to spend a week at the beach during spring break and her employer has agreed to give her the time off, but without pay. The €500 in lost wages would be an opportunity cost of taking the week off to be at the beach. Example 2: A company can invest a large amount of money in land that may be a place for future store or in high-grade bonds. If the land is acquired the opportunity cost would be the investment income that could have been realized if the bonds had been purchased instead.

6. 6 2.Differential cost and revenue Decisions involve choosing between alternatives. In business decisions, each alternative will have certain costs and benefits that must be compared to the costs and benefits of the other available alternatives. A difference in costs between any two alternatives is known as a differential cost. A difference in revenues between any two alternatives is known as a differential revenue. A differential cost is also known as incremental cost, if there is an increase in cost from one alternative to another, or decremental cost if there is a decrease in cost from one alternative to another

7. 7 3.A sunk cost is a cost that has already been incurred and that can not be changed or avoided regardless of what a manager decides to do. Example: A company paid €50,000 several years ago for a special purpose machine to make a product. But in nowadays the specific product is old-fashioned and is no longer being sold. It would be folly to continue producing this product. Thus the cost of buying the machine has already been incurred and cannot be a differential cost in any future decision. For that reason this cost is sunk and should be ignored in decisions.

8. 8 Identifying Relevant Costs and benefits Only those costs and benefits that differ in total between alternatives are relevant in a decision. If a cost will be the same regardless of the alternative selected, then the decision has no effect on the cost and it can be ignored. For example if you are trying to decide whether to go to a movie or rent a DVD for the evening, the rent on your apartment is irrelevant – because it will remain the same whatever decision you make. On the other hand, the cost of the movie ticket and cost of renting the DVD would be relevant in the decision because they are avoidable costs.

9. 9 An avoidable Cost is a cost that can be eliminated in whole or in part by choosing one alternative over another. In the previous example by choosing the alternative of going to the movie, the cost of renting the DVD can be avoided. By choosing the alternative of renting the DVD, the cost of the movie ticket can be avoided. On the other hand the rent is not an avoidable cost because you will continue rent your apartment whatever you decide. Avoidable costs are relevant costs. Unavoidable costs are never relevant and include two broad categories:  Sunk costs.  Future costs that do not differ between the alternatives. Future costs that differ between alternatives are relevant.

10. 10 Sunk Costs are always the same no matter what alternatives are being considered: therefore they are irrelevant and should be ignored when making decisions. Quick Check 1 In a decision of whether to buy a new car and exchange your old car or just keep your old car, which of the following are sunk costs? a. The cost of licensing the new car. b. The cost of licensing your old car next year if you keep it. c. The amount you paid for your old car. d. The amount you paid to repair your old car last month in case you wanted to sell it.

11. 11 Quick Check 1 a. The cost of licensing the new car. b. The cost of licensing your old car next year if you keep it. c. The amount you paid for your old car. d. The amount you paid to repair your old car last month in case you wanted to sell it. Both of these costs have already been incurred and no decision now or in the future can change that fact.

12. 12 Quick Check 2 In a decision of whether to buy a new car and exchange your old car or just keep your old car, which of the following are future costs that don’t differ between the alternatives? a. Monthly parking fees. b. Auto insurance. c. Theater tickets. d. Driver’s license renewal fee.

13. 13 Quick Check 2 a. Monthly parking fees. b. Auto insurance. c. Theater tickets. d. Driver’s license renewal fee. Auto insurance premiums usually depend on the car you drive. All of the other costs should be the same whether you drive your old car or your new car.

14. 14 Future costs that differ between alternatives are relevant. For example when deciding whether to go to a movie or rent a DVD, the cost of buying the movie ticket and the cost of rending a DVD have not yet been incurred and so are future costs that differ between alternatives and therefore are relevant.

15. 15 In managerial accounting the terms avoidable cost, differential cost,incremental cost and relevant cost are identical-equivalent. In order to identify these costs 2 steps can be followed: 1.Eliminate costs and benefits that do not differ between alternatives. These irrelevant costs consist of a) sunk costs and b) future costs that do not differ between alternatives. 2. Use the remaining costs and benefits that do differ between alternatives in making the decision. The costs that remain are the differential or avoidable costs.

16. 16 Let’s look at the White Company example. Total and Differential approached

17. 17 A manager at White Co. wants to rent a new labor- saving machine for €3000 per year. Data regarding the company’s annual sales and costs with and without the new machine are shown below: Current Situation Situation with New Machine Units produced and sold 5000 5000 Selling price per unit €40 €40 Direct Materials cost per unit €14 €14 Direct Labor costs per unit €8 €5 Variable overhead cost per unit €2 €2 Fixed costs general €62000 €62000 Fixed costs of new machine (rent) €3000

18. 18 Should the manager Rent the new machine?

19. 19 a)Look at the comparative cost and revenue analysis Total and Differential Costs Current Situation Situation with New Machine Differential Cost and Benefits Sales(5000*40) 200,000 0 Less Variable costs: Direct Materials (5000*14) 70,000 0 Direct Labor (5000*8) (5000*5) 40,00025,00015,000 Variable overhead (5000*2) 10,000 0 Contribution Margin80,00095,000 Less Fixed Costs: General62,000 0 Rent of new machine03000(3,000) Net Operating Income18,00030,00012,000

20. 20 Observations: 1.A positive number in the Differential costs and benefits column indicates that the difference between the alternatives favor the new machine, if the number was negative it would mean that the difference favors the current situation. 2.A zero in the Differential costs and benefits column indicates that the total amount for the item is exactly the same for both alternatives. Any cost or benefit that is the same for both alternatives will have no impact on which alternative is preferred. This is the reason that costs and benefits that do not differ between alternatives are irrelevant and can be ignored.

21. 21 Relevant Cost Analysis Let’s look at a more efficient way to analyze this decision.

22. 22 Relevant Cost Analysis Just focus on the costs that differ between alternatives.

23. 23 b) Relevant Cost Analysis: We would have arrive at the same solution much more quickly by ignoring altogether the irrelevant cost and benefits b) Relevant Cost Analysis: We would have arrive at the same solution much more quickly by ignoring altogether the irrelevant cost and benefits Net advantage to rending the new machine Decrease in direct labor costs (5000*3 savings) 15000 Increase in Fixed expenses (3000) Net annual cost savings from renting the new machine 12000

24. 24  The selling price per unit and the numbers of units sold do not differ between the alternatives.  The direct materials cost and the variable overhead cost will be the same for the two alternatives and can be ignored.  The general Fixed expenses do not differ between the alternatives so they can be ignored as well.  The only costs that differ between the alternatives are direct labor costs and the fixed rental cost of the new machine. So these are the only relevant costs.

25. 25 Different Costs for Different Purposes Costs that are relevant in one decision are not necessarily relevant in another. Managers need different costs for different purposes. For one purpose, a particular group of costs may be relevant, for another purpose a completely different group of costs may be relevant. Thus, each decision situation must be carefully analyzed to isolate the relevant costs. Otherwise, irrelevant data may confuse the situation and lead to a bad decision

26. 26 Adding/Dropping Segments One of the most important decisions managers make is whether to add or drop a business segment such as a product or a store. This kind of decisions are important because there is an effect on the Net Profit. Let’s see how relevant costs should be used in this decision.

27. 27 Example of Adding/Dropping Segments Due to the declining popularity of digital watches, Lovell Company’s digital watch line has not reported a profit for several years. An income statement for last year is shown on the next screen. Note that the equipment used to manufacture digital watches has no resale value or alternative use. Should Lovell retain or drop the digital watch segment?

28. 28 Segment (digital watches) Income Statement Digital Watches Sales of digital watches $ 500.000 Less: variable expenses of digital watches Variable mfg. costs $ 120.000 Variable shipping costs 5.000 Commissions 75.000 200.000 Contribution margin of digital watches $ 300.000 Less: fixed expenses Rent (allocation to this product) $ 60.000 Salary of line manager 90.000 Depreciation of equipment 50.000 Advertising – direct 100.000 Insurance for the stock of digital watches 70.000 General admin. Expenses (allocation to this product) 30.000 400.000 Net loss of digital watches $ (100.000)

29. 29 1. A Contribution Margin Approach to solve the example: DECISION RULE Lovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings exceed the lost contribution margin. Let’s look at this solution. DECISION RULE Lovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings exceed the lost contribution margin. Let’s look at this solution.

30. 30 If the digital watch line is dropped the company will lose €300,000 per year in contribution margin but it will avoid some fixed costs. As we have seen not all costs are avoidable. For example some of the costs associated with a product line may be sunk costs like depreciation. Other costs may be allocated as common costs like rent or general administration expenses. These are future costs that will not change whether the digital line stop or not. If by dropping a line of product a company is able to avoid more fixed costs than it loses in contribution margin then it will be better off if the product line is eliminated since the Net Profit will be improved. On the other hand if the company is not able to avoid as much in fixed costs as it loses in contribution margin the problematic product line should be kept. RULE of previous slide

31. 31 Not Avoidable costs: 1. Depreciation: the equipment used to manufacture digital watches has no resale value if the digital watches are dropped or alternative use because it is specially made for this company for this product line. So this is a sunk cost: it will happen in anyway. 2. Rent: the yearly rent it concerns the whole company and is under a long term lease agreement. It is allocated to the product lines on the basis of sales euro. 3. General Administrative expenses: are the cost of accounting and general management and they are allocated to the product lines on the basis of sales euro. These costs will not change if the digital watch line is dropped. The manager is asking ‘ What costs can I avoid if I drop this product line?’ as he knows that some expenses are not avoidable:

32. 32 A Contribution Margin Approach In this case the fixed costs that can be avoided by dropping the product line are less than the contribution margin that will be lost. Therefore based on the data given the digital line should not be stop.

33. 33 2. A Comparative Income Approach to solve the example The Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment. Let’s look at this second solution.

34. 34 Comparative Segment Income Approach Solution Keep Digital Watches Drop Digital Watches Difference Sales $ 500.000 $ - $ (500.000) Less variable expenses: - Mfg. expenses 120.000 - Shipping Costs 5.000 - Commissions 75.000 - Total variable expenses 200.000 - Contribution margin 300.000 - (300.000) Less fixed expenses: Rent 60.000 - Salary of line manager 90.000 - Depreciation 50.000 - Advertising - direct 100.000 - Insurance for the stock of digital watches 70.000 - General admin. expenses 30.000 - Total fixed expenses 400.000 140.000 260.000 Net loss $(100.000) $(140.000) $ (40.000)

35. 35 If the digital watch line is dropped, the net book value of the equipment would be written off. The depreciation that would have been taken will flow through the income statement as a loss instead. But we wouldn’t need a manager for the product line anymore. On the other hand, the rent would be the same. So this cost really isn’t relevant. If the digital watch line is dropped, the company gives up its contribution margin

36. 36 Beware of Allocated Fixed Costs Why should we keep the digital watch segment when it’s showing a loss?

37. 37 Beware of Allocated Fixed Costs The answer lies in the way we allocate common fixed costs to our products.

38. 38 Beware of Allocated Fixed Costs Our allocations can make a segment look less profitable than it really is.

39. 39 The Make or Buy Decision A decision concerning whether an item should be produced internally or purchased from an outside supplier is called a “make or buy” decision. Let’s look at the Essex Company example.

40. 40 Some companies, the manufacturing one, are producing internally many, some or all the parts of the finished product that they selling to consumers. This has the following advantages:  1. The company is less dependent on its suppliers regarding the final product, and is able to ensure a smoother flow of parts and materials for production. For example a hit against a supplies who is providing major parts into a company will interrupt the operations of the company for many months. But if this company is producing by its self its own parts will be able to continue operations.  2. Many Firms feel that they can control quality better by producing their own parts and materials rather than relying on an outsider supplier.  3. This kind of company realizes profits from the parts and materials that is making rather than buying.

41. 41 On there other hand there can be advantages if a company buys a part/or parts from an exterior supplies on price and on quality. That is why by pooling demand from a number of companies a supplier may be able to enjoy economies of scale in research and development and in manufacturing. These economies of scale can result in higher quality and lower costs than it would be possible if the company were to attempt to make the parts on its own.

42. 42 Economies of scale are the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a facility and the usage levels of other inputs increase. Diseconomies of scale is the opposite. The increase in efficiency of production as the number of goods being produced increases. Typically, a company that achieves economies of scale lowers the average cost per unit through increased production since fixed costs are shared over an increased number of goods. There are two types of economies of scale: -External economies - the cost per unit depends on the size of the industry, not the firm. -Internal economies - the cost per unit depends on size of the individual firm.

43. 43 The Make or Buy Decision Essex manufactures part A that is currently used in one of its products. The cost per unit of this part is:

44. 44 The Make or Buy Decision The special equipment used to manufacture part A has no resale value. The total amount of general factory overhead, is common cost and is allocated between the product- parts created. It would be unaffected by this decision. The $30 total cost per unit 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?

45. 45 The Make or Buy Decision The special equipment has no resale value and is a sunk cost. Not avoidable and is irrelevant. If the product is dropped, it will be reallocated to other products.

46. 46 The Make or Buy Decision DECISION RULE eliminating In deciding whether to accept the outside supplier’s offer, Essex isolated the relevant costs of making the part by eliminating: –The sunk costs. –The future costs that will not differ between making or buying the parts. DECISION RULE eliminating In deciding whether to accept the outside supplier’s offer, Essex isolated the relevant costs of making the part by eliminating: –The sunk costs. –The future costs that will not differ between making or buying the parts.

47. 47 Since it cost $160,000 less to continue to make the part A the company should reject the offer of the outsider supplier. However the company may wish to consider one additional factor before coming to a final decision. This factor is the opportunity cost of the space being used to produce part A.

48. 48 The Matter of Opportunity Cost OC: the benefits you could have received by taking an alternative action. Opportunity costs are not actual money spend and are not recorded in the accounts of an organization. They represent economic benefits that are given up as a result of following some course of action.

49. 49 Quick Check Quick Check Which of the following are opportunity costs of attending the university? a. Tuition. b. Books. c. Lost wages. d. Not enough time for other interests.

50. 50 Quick Check Quick Check Which of the following are opportunity costs of attending the university? a. Tuition. b. Books. c. Lost wages. d. Not enough time for other interests. Opportunity costs do not have to involve money.

51. 51 In the case of Essex manufactures the opportunity cost would be the empty space from stopping the production of part A which could be use for other purpose. For example it could be used to produce a new product which would generate a net profit of $180,000. Under these conditions Essex would be better off to accept the supplier’s offer and to use the available space to produce the new product line: Make Buy Total annual of part 4A: 340,000 500,000 Opportunity Cost: 180,000 Total Cost 520,000 500,000 Difference in favor of purchasing 20,000 from supplier