©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Relevant Information and Decision Making: Production Decisions Chapter 6

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 1 Use opportunity cost to analyze the income effects of a given alternative.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Opportunity, Outlay, and Differential Costs Incremental cost includes all of the costs of the other alternative plus some additional costs. Incremental cost includes all of the costs of the other alternative plus some additional costs. Differential cost (revenue) is the difference in total cost (revenue) between two alternatives. Differential cost (revenue) is the difference in total cost (revenue) between two alternatives.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Opportunity, Outlay, and Differential Costs An outlay cost requires a cash disbursement. An opportunity cost is the maximum available contribution to profit forgone (or passed up) by using limited resources for a particular purpose. An opportunity cost is the maximum available contribution to profit forgone (or passed up) by using limited resources for a particular purpose.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 2 Decide whether to make or to buy certain parts or products.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Make-or-Buy Decisions Managers often must decide whether to produce a product or service within the firm or purchase it from an outside supplier. Managers often must decide whether to produce a product or service within the firm or purchase it from an outside supplier.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Make-or-Buy Example Direct material$ 60,000$.06 Direct labor 20, Variable overhead 40, Fixed overhead 80, Total costs$200,000$.20 Direct material$ 60,000$.06 Direct labor 20, Variable overhead 40, Fixed overhead 80, Total costs$200,000$.20 Nantucket Nectars Company Cost of Making 12-ounce Bottles Total Cost for 1,000,000 bottles Cost per bottle

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Make-or-Buy Example Another manufacturer offers to sell Nantucket the same part for $.18. Another manufacturer offers to sell Nantucket the same part for $.18. If the company buys the part, $50,000 of fixed overhead would be eliminated. If the company buys the part, $50,000 of fixed overhead would be eliminated. Should Nantucket make or buy the part?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Relevant Cost Comparison Purchase cost$180,000$.18 Direct material$ 60,000$.06 Direct labor 20, Variable overhead 40, Fixed OH avoided by not making 50, not making 50, Total relevant costs$170,000$.17$180,000$.18 Difference in favor of making$ 10,000$.01 of making$ 10,000$.01 Purchase cost$180,000$.18 Direct material$ 60,000$.06 Direct labor 20, Variable overhead 40, Fixed OH avoided by not making 50, not making 50, Total relevant costs$170,000$.17$180,000$.18 Difference in favor of making$ 10,000$.01 of making$ 10,000$.01 Total Per Bottle Total MakeBuy

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Make or Buy and the Use of Facilities Suppose Nantucket can use the released facilities in other manufacturing activities to produce a contribution to profits of $55,000, or can rent them out for $35,000. Suppose Nantucket can use the released facilities in other manufacturing activities to produce a contribution to profits of $55,000, or can rent them out for $35,000. What are the alternatives?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Make or Buy and the Use of Facilities Rent revenue$ —$ —$ 25$ — Contribution from other products — — — 55 other products — — — 55 Variable cost of bottles (170) (180) (180) (180) Net relevant costs$(170)$(180)$(155)$(125) Rent revenue$ —$ —$ 25$ — Contribution from other products — — — 55 other products — — — 55 Variable cost of bottles (170) (180) (180) (180) Net relevant costs$(170)$(180)$(155)$(125) Make Buy and leavefacilitiesidle rent Out facilities Buy and use facilities for other products (000)

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 3 Decide whether a joint product should be processed beyond the split-off point.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Joint Product Costs Joint products have relatively significant sales values. Joint products have relatively significant sales values. They are not separately identifiable as individual products until their split-off point. They are not separately identifiable as individual products until their split-off point. The split-off point is that juncture of manufacturing where the joint products become individually identifiable. The split-off point is that juncture of manufacturing where the joint products become individually identifiable.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Joint Product Costs Separable costs are any costs beyond the split-off point. Separable costs are any costs beyond the split-off point. Joint costs are the costs of manufacturing joint products before the split-off point. Joint costs are the costs of manufacturing joint products before the split-off point.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Joint Product Costs Suppose Dow Chemical Company produces two chemical products, X and Y, as a result of a particular joint process. Suppose Dow Chemical Company produces two chemical products, X and Y, as a result of a particular joint process. The joint processing cost is $100,000. Both products are sold to the petroleum industry to be used as ingredients of gasoline. Both products are sold to the petroleum industry to be used as ingredients of gasoline.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Joint Product Costs 1 million liters of X at a selling price of $.09 = $90,000 1 million liters of X at a selling price of $.09 = $90, ,000 liters of Y at a selling price of $.06 = $30, ,000 liters of Y at a selling price of $.06 = $30,000 Total sales value at split-off is $120,000 Total sales value at split-off is $120,000 Joint-processing cost is $100,000 Joint-processing Split-off point

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Illustration of Sell or Process Further Suppose the 500,000 liters of Y can be processed further and sold to the plastics industry as product YA. plastics industry as product YA. Suppose the 500,000 liters of Y can be processed further and sold to the plastics industry as product YA. plastics industry as product YA. The additional processing cost would be $.08 per liter for manufacturing and distribution, a total of $40,000. The additional processing cost would be $.08 per liter for manufacturing and distribution, a total of $40,000. The net sales price of YA would be $.16 per liter, a total of $80,000. The net sales price of YA would be $.16 per liter, a total of $80,000.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Illustration of Sell or Process Further Revenues$30,000$80,000$50,000 Separable costs beyond split-off beyond $.08 – 40,000 $.08 – 40,000 40,000 Income effects$30,000$40,000$10,000 Revenues$30,000$80,000$50,000 Separable costs beyond split-off beyond $.08 – 40,000 $.08 – 40,000 40,000 Income effects$30,000$40,000$10,000 Sell at Split-off as Y Process Further and Sell as YA Difference

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 4 Identify irrelevant information in disposal of obsolete inventory.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Irrelevance of Past Costs The ability to recognize and thereby ignore irrelevant costs is important to decision makers. The ability to recognize and thereby ignore irrelevant costs is important to decision makers.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Example of Irrelevance of Obsolete Inventory Suppose General Dynamics has 100 obsolete aircraft parts in its inventory. Suppose General Dynamics has 100 obsolete aircraft parts in its inventory. The original manufacturing cost of these parts was $100,000. The original manufacturing cost of these parts was $100,000.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Example of Irrelevance of Obsolete Inventory General Dynamics can... remachine the parts for $30,000 and then sell them for $50,000, or remachine the parts for $30,000 and then sell them for $50,000, or scrap them for $5,000. Which should it do?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Example of Irrelevance of Obsolete Inventory Expected future revenue$ 50,000$ 5,000$45,000 Expected future costs 30, ,000 Relevant excess of revenue over costs$ 20,000$ 5,000$15,000 revenue over costs$ 20,000$ 5,000$15,000 Accumulated historical inventory cost* 100, ,000 0 inventory cost* 100, ,000 0 Net loss on project$(80,000)$ (95,000)$15,000 * Irrelevant because it is unaffected by the decision. Expected future revenue$ 50,000$ 5,000$45,000 Expected future costs 30, ,000 Relevant excess of revenue over costs$ 20,000$ 5,000$15,000 revenue over costs$ 20,000$ 5,000$15,000 Accumulated historical inventory cost* 100, ,000 0 inventory cost* 100, ,000 0 Net loss on project$(80,000)$ (95,000)$15,000 * Irrelevant because it is unaffected by the decision. DifferenceRemachineScrap

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Book Value of Old Equipment The book value of equipment is not a relevant consideration in deciding whether to replace the equipment. The book value of equipment is not a relevant consideration in deciding whether to replace the equipment. Because it is a past, not a future cost.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Book Value of Old Equipment Depreciation is the periodic allocation of the cost of equipment. Depreciation is the periodic allocation of the cost of equipment. The equipment’s book value (or net book value) is the original cost less accumulated depreciation. The equipment’s book value (or net book value) is the original cost less accumulated depreciation.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Book Value of Old Equipment Suppose a $10,000 machine with a 10-year life span has depreciation of $1,000 per year. Suppose a $10,000 machine with a 10-year life span has depreciation of $1,000 per year. What is the book value at the end of 6 years? Original cost$10,000 Accumulated depreciation (6 × $1,000) 6,000 Book value$ 4,000 Original cost$10,000 Accumulated depreciation (6 × $1,000) 6,000 Book value$ 4,000

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 5 Decide whether to keep or replace equipment.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Keep or Replace an Old Machine ? Original cost$10,000$8,000 Useful life in years 104 Current age in years 60 Useful life remaining in years 44 Accumulated depreciation$ 6,0000 Book value$ 4,000 N/A Disposal value (in cash) now$ 2,500 N/A Disposal value in 4 years 00 Annual cash operating costs$ 5,000$3,000 Original cost$10,000$8,000 Useful life in years 104 Current age in years 60 Useful life remaining in years 44 Accumulated depreciation$ 6,0000 Book value$ 4,000 N/A Disposal value (in cash) now$ 2,500 N/A Disposal value in 4 years 00 Annual cash operating costs$ 5,000$3,000 OldMachineReplacementMachine

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Keep or Replace an Old Machine? A sunk cost is a cost that has already been incurred and, therefore, is irrelevant to the decision-making process. A sunk cost is a cost that has already been incurred and, therefore, is irrelevant to the decision-making process.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Relevance of Equipment Data  Book value of old equipment  Disposal value of old equipment  Gain or loss on disposal  Cost of new equipment  Book value of old equipment  Disposal value of old equipment  Gain or loss on disposal  Cost of new equipment

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Book Value of Old Equipment The book value of old equipment is irrelevant because it is a past (historical) cost. The book value of old equipment is irrelevant because it is a past (historical) cost. Therefore, depreciation on old equipment is irrelevant. Therefore, depreciation on old equipment is irrelevant.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Disposal Value of Old Equipment The disposal value of old equipment is relevant because it is an expected future inflow that usually differs among alternatives. The disposal value of old equipment is relevant because it is an expected future inflow that usually differs among alternatives.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Gain or Loss on Disposal This is the difference between book value and disposal value. This is the difference between book value and disposal value. It is therefore a meaningless combination of irrelevant (book value) and relevant items (disposal value). It is therefore a meaningless combination of irrelevant (book value) and relevant items (disposal value). It is best to think of each separately.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cost of New Equipment The cost of the new equipment is relevant because it is an expected future outflow that will differ among alternatives. The cost of the new equipment is relevant because it is an expected future outflow that will differ among alternatives.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cost Comparison Cash operating costs$20,000$12,000$8,000 Old equipment (book value): Depreciation, or 4,000–– Depreciation, or 4,000–– Lump-sum write-off– 4,000– Lump-sum write-off– 4,000– Disposal value– (2,500) 2,500 New machine acquisition cost– 8,000 (8,000) acquisition cost– 8,000 (8,000) Total costs$24,000$21,500$2,500 Cash operating costs$20,000$12,000$8,000 Old equipment (book value): Depreciation, or 4,000–– Depreciation, or 4,000–– Lump-sum write-off– 4,000– Lump-sum write-off– 4,000– Disposal value– (2,500) 2,500 New machine acquisition cost– 8,000 (8,000) acquisition cost– 8,000 (8,000) Total costs$24,000$21,500$2,500 DifferenceKeepReplace Four Years Together

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 6 Explain how unit costs can be misleading.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Beware of Unit Costs There are two major ways to go wrong when using unit costs in decision making: There are two major ways to go wrong when using unit costs in decision making: 1)including irrelevant costs 2)comparing unit costs not computed on the same volume basis 2)comparing unit costs not computed on the same volume basis

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Example of Volume Basis Decision Assume that a new $100,000 machine with a five-year life can produce 100,000 units a year at a variable cost of $1 per unit, as opposed to a variable cost per unit of $1.50 with an old machine. Assume that a new $100,000 machine with a five-year life can produce 100,000 units a year at a variable cost of $1 per unit, as opposed to a variable cost per unit of $1.50 with an old machine. Is the new machine a worthwhile acquisition?

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Example of Volume Basis Decision Units 100, ,000 Variable cost per unit$1.50$1.00 Variable costs$150,000$100,000 Straight-line depreciation 0 20,000 Total relevant costs$150,000$120,000 Unit relevant costs$1.50$1.20 Units 100, ,000 Variable cost per unit$1.50$1.00 Variable costs$150,000$100,000 Straight-line depreciation 0 20,000 Total relevant costs$150,000$120,000 Unit relevant costs$1.50$1.20 Old Machine New Machine

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Example of Volume Basis Decision It appears that the new machine will reduce costs by $.30 per unit. It appears that the new machine will reduce costs by $.30 per unit. However, if the expected volume is only 30,000 units per year, the unit costs change in favor of the old machine. However, if the expected volume is only 30,000 units per year, the unit costs change in favor of the old machine.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Example of Volume Basis Decision Units 30,000 30,000 Variable cost per unit$1.50$1.00 Variable costs$45,000$30,000 Straight-line depreciation 0 20,000 Total relevant costs$45,000$50,000 Unit relevant costs$1.50$ Units 30,000 30,000 Variable cost per unit$1.50$1.00 Variable costs$45,000$30,000 Straight-line depreciation 0 20,000 Total relevant costs$45,000$50,000 Unit relevant costs$1.50$ Old Machine New Machine

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 7 Discuss how performance measures can affect decision making.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Decision Making and Performance Evaluation To motivate managers to make the right choice, the method used to evaluate performance should be consistent with the decision model. To motivate managers to make the right choice, the method used to evaluate performance should be consistent with the decision model.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Decision Making and Performance Evaluation Consider the replacement decision, discussed earlier, where replacing the machine had a $2,500 advantage over keeping it. Consider the replacement decision, discussed earlier, where replacing the machine had a $2,500 advantage over keeping it. Because performance is often measured by accounting income, consider the accounting income in the first year after replacement compared with that in years 2, 3, and 4. Because performance is often measured by accounting income, consider the accounting income in the first year after replacement compared with that in years 2, 3, and 4.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Decision Making and Performance Evaluation Cash operating costs$5,000$3,000$5,000$3,000 costs$5,000$3,000$5,000$3,000 Depreciation 1,000 2,000 1,000 2,000 Loss on disposal ($4,000 – $2,500) 0$1, ($4,000 – $2,500) 0$1, Total charges against revenue$6,000$6,500$6,000$5,000 against revenue$6,000$6,500$6,000$5,000 Cash operating costs$5,000$3,000$5,000$3,000 costs$5,000$3,000$5,000$3,000 Depreciation 1,000 2,000 1,000 2,000 Loss on disposal ($4,000 – $2,500) 0$1, ($4,000 – $2,500) 0$1, Total charges against revenue$6,000$6,500$6,000$5,000 against revenue$6,000$6,500$6,000$5,000 KeepReplaceKeepReplace Year 1 Years 2, 3, and 4

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Decision Making and Performance Evaluation If the machine is kept rather than replaced, first-year costs will be $500 lower ($6,500 – $6,000), and first-year income will be $500 higher. If the machine is kept rather than replaced, first-year costs will be $500 lower ($6,500 – $6,000), and first-year income will be $500 higher.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 8 Construct absorption and contribution format income statements and identify which is better for decision making.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Absorption Approach The absorption approach is a costing approach that considers all factory overhead (both variable and fixed) to be product (inventoriable) costs. The absorption approach is a costing approach that considers all factory overhead (both variable and fixed) to be product (inventoriable) costs. Factory overhead becomes an expense in the form of manufacturing cost of goods sold only as sales occur. Factory overhead becomes an expense in the form of manufacturing cost of goods sold only as sales occur.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Contribution Approach In contrast, the contribution approach is used by many companies for internal (management accounting) reporting. In contrast, the contribution approach is used by many companies for internal (management accounting) reporting. It emphasizes the distinction between variable and fixed costs. It emphasizes the distinction between variable and fixed costs. The contribution approach is not allowed for external financial reporting. The contribution approach is not allowed for external financial reporting.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Comparing Contribution and Absorption Approaches VariablecostsVariablecosts FixedcostsFixedcosts ManufacturingcostsManufacturingcostsNonmanufacturingcostsNonmanufacturingcosts A. Variable manufacturingcosts manufacturingcosts B. Variable nonmanufacturingcosts nonmanufacturingcosts C. Fixed manufacturingcosts manufacturingcosts D. Fixed nonmanufacturingcosts nonmanufacturingcosts

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Comparing Contribution and Absorption Approaches Contributionincomestatement Sales Less: A + B = Contribution margin Less: C + D = Profit Sales Less: A + B = Contribution margin Less: C + D = Profit AbsorptionincomestatementSales Less: A + C = Gross margin Less: B + D = Profit Sales Less: A + C = Gross margin Less: B + D = Profit

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 9 Understand the relationship between accounting information and decisions in the production stage of the value chain.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Production Stage of the Value Chain In the production stage of the value chain managers make decisions about product mix, production equipment, labor, and all other factors that affect the creation of goods and services. In the production stage of the value chain managers make decisions about product mix, production equipment, labor, and all other factors that affect the creation of goods and services. Managers need timely and relevant accounting information in order to make these decisions. Managers need timely and relevant accounting information in order to make these decisions.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton End of Chapter 6