13 Relevant Costs for Decision Making Chapter Future revenues or costs that differ among alternatives. Is the cost of equipment purchased in the past relevant? The cost of new equipment? Are fixed costs ever relevant? Variable costs?

Cost Concepts for Decision Making Avoidable cost  important to consider when comparing one alternative to another Sunk cost Differential cost or  a cost of the past that cannot be avoided Opportunity cost  a benefit (revenue or gain) of an alternative that is not chosen

Replacing Equipment  The cost of the old equipment is irrelevant.  And the loss on the sale of the old equipment is irrelevant.  Don’t get trapped by past mistakes!  Relevant factors  current market value of the old  cost & expected life of the new equipment  future output  future operating expenses

Keep Old Oper. Costs (6 yrs) Purchase of new Sale of old Net cash flow Buy New Impact of buying new  Old machine: $50,000 cost, $10,000 accum. depreciation; $7,000 market value  New machine: $25,000 cost; 6 year life  New machine will decrease annual operating costs from $10,000 to $6,000.

Adding and Dropping Segments Keep Rnd Revenue$1,000,000 Variable expenses (410,000) Deprec – special equip(95,000) General factory OH(200,000) Income$ 60,000 Drop Rnd Advertising - traceable (216,000) Review Problem, p. 601 Impact of dropping R.I. Depreciation on equip is irrelevant! Supervisor salaries(19,000) Beware of allocated fixed costs!

Make or Buy Decisions Make Outside purchase DM Variable MOH Fixed MOH - common Total Buy DL Exer. 13-9, p. 608 Impact of outsourcing Some fixed costs cannot be avoided Fixed MOH - traceable

Special Order Revenue DM Variable selling & adm Additional fixed costs Total effect  if regular sales are unaffected, it’s easiest to look at the revenue and costs from special order only Exer , Part 1, p. 609 Special Sales Order DL Variable MOH

Information needed:  Number of extra units  Selling price per unit  Variable cost per unit  Changes in fixed costs May need to be calculated. Special Sales Order (cont.)

Utilization of a Constrained Resource A Sales$ Variable:DL ($8/hr) CM per unit B $ Other Exer. 13-5, p. 606 C $ Decision based not on CM per unit… … but on CM per constrained resource.

Managing Constraints  “Bottleneck”: the machine or process that limits overall output  Managers should select product mix that maximizes total contribution margin.  Managers should try to increase capacity at the bottleneck:  working overtime  subcontracting of bottleneck process  additional investment  reducing defects

A Sales value after $80,000 Incremental rev / unit B $150,000 Less: Sales value before Exer. 13-6, p. 606 C $75,000 Sell or Process Further

 AgroCorp prepares fruit and vegetable products in a large processing plant.  Currently sells 28,000 bags of $2.10. Cost of potatoes=$25,200; cost of package=$0.03; DL=$9,000; MOH= DL x 1.2 = $10,800.  Possibility: process the potatoes further to prepare potato flakes.  35,000 boxes of $1.80; 14,000 pounds of potato $0.02  Cost of potato flake box = $0.05  Direct labor cost will increase by $2,000  New rental equipment = $3,200 / year Sell or Process Further

Bags Sales ($2.10 / bag) Packaging ($.03 / bag) MOH allocated (DL x 1.2) (10,800) Flakes Raw materials Profit$ 12,960 Impact of switching to flakes Sales ($2.10 / bag; $1.90 / box) Profit before allocated costs Beware of allocated fixed costs!