1. Chapter Four
Chapter 4.

2. Relevant Information for Special Decisions
Chapter Four
Relevant Information for Special Decisions
In chapter 4 we will see exactly how managers separate relevant information from that information that is irrelevant to the decision-making process. It is important that all significant decisions be made based upon only relevant information. The task of separating relevant from irrelevant information can become quite complex.

3. Relevant Information
Two 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 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. Just sell the stock and buy the car!
Sunk Cost
A sunk cost has been incurred in a past transaction and cannot be changed. It is not relevant for making current decisions.
Wish I hadn’t bought that stock. Cost me $25,000, and now it’s worth only $15,000. I really need a car but don’t have the cash!
Part I
A 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 emotional attachments to some costs that color the decision process.
Part II
Here is a perfect example of a sunk cost. 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.
Just sell the stock and buy the car!

5. I don’t want to take the loss!
Sunk Cost
A sunk cost has been incurred in a past transaction and cannot be changed. It is not relevant for making current decisions.
You’ve already taken the loss. The $25,000 is a sunk cost. Like I said, sell the stock and buy the car you need.
I don’t want to take the loss!
The coworker tries to explain that the person has already taken a loss on the $25,000 original investment and that that $25,000 is a sunk cost. If you really need a car, just sell the stock and buy the car. The emotional response from the coworker is I just don’t want to take the loss.

6. Relevant (Differential) Revenues
Relevant revenues must (1) be future oriented and (2) differ for the alternatives under consideration. Since relevant revenues differ between the alternatives, they are sometimes called differential revenues.
Like relevant costs, relevant revenues must be future oriented and differ between the alternatives under consideration. Relevant revenues are sometimes referred to as differential revenues.

7. Relevant (Avoidable) Costs
Unit-level Costs
Avoided by eliminating one unit of product.
Batch-level Costs
Avoided when a batch of work is eliminated.
Product-level Costs
Avoided 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 an 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 Costs
Some costs may be avoided if a business segment is eliminated.

8. Relevance Is an Independent Concept
Management at Better Bakery Products is debating whether to add a new product, either cakes or pies, to the company’s product line. Projected costs are shown:
Part I
Here we have the situation where a company is attempting to decide whether to add cakes or pies to its product line. Take a look at the cost information that applies to the cakes and the pies.
Part II Under either alternative a new production supervisor must be hired at a cost of $25,000 per year. The cakes are distributed under a nationally advertised label and therefore requires no additional advertising. Pies are marketed under the company’s own name and will require an advertising campaign. Let’s see how we identify relevant costs.
Under either alternative, a new production supervisor must be hired at a cost of $25,000 per year. Cakes are distributed under a nationally advertised label. Pies are marketed under the company’s own name and will require new advertising.

9. Relevance Is an Independent Concept
Which costs are relevant?
Material costs are relevant because they differ. Fifty cents can be avoided by choosing cakes instead of pies. Labor costs and the supervisor’s salary are not relevant because they do not differ. The advertising costs can be avoided if the company elects to make cakes. Whether a cost is fixed or variable has no bearing on its relevance.
If we choose cakes instead of pies we can avoid $.50 in material costs. Labor costs do not differ and are therefore not relevant. The supervisor’s salary is not relevant because it does not differ under the two alternatives. The advertising costs can be avoided if the company decides to make cakes rather than pies. In determining whether a cost is relevant or not it makes no difference whether it’s a fixed cost or a variable cost.

10. 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 another. Like other relevant costs, opportunity costs are future oriented and must differ between the alternatives being considered. The problem with opportunity costs is that they are extremely difficult to measure.

11. Check Yourself
Aqua, Inc., makes statues for use in fountains. On January 1, 2003, the company paid $13,500 for a mold to make a particular type of statue. The mold had an expected life of four years and a salvage value of $1,500. On January 1, 2005, the mold had a market value of $3,000, and a salvage value of $1,200. The expected useful life did not change. What is the relevant cost of using the mold during 2005?
Part I Read this information carefully about a mold purchased by Aqua to make statues for fountains. The mold was purchased on January What we would like to know is what is the relevant cost of using the mold during 2005?
Part II
The correct answer is $900. We would take the market value of $3000 less the salvage value of $1200 and divide by the remaining life of two years.
Part III
There is another option however. Aqua could avoid the $900 cost by selling the mold for its market value of $3000.
($3,000 – $1,200) ÷ 2 years = $900
Of course, Aqua could avoid the cost by selling the mold for its market value of $3,000.

12. 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 receive a one-time special order and must make a decision to accept or reject the offer.

13. 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 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

14. 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, profitability will increase by $11,800.
Part I
A 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 offer?
Part II
The differential revenue is $50,000, that 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 one-time offer would contribute $11,800 to income, so we should accept the offer.

15. Special Order Decision
If Premier can increase income by selling its printers for $250, can the company reduce its normal selling price to $250?
Part I If the one-time special offer proved profitable, could Premiere afford 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.

16. 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 I
Sometimes 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 assured 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 it 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.

17. 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 An outside supplier offers to sell an unlimited number of printers to Premier for $240 each. Remember that the unit product cost 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, batch 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

18. Outsourcing Decisions
Step 2 Compare the avoidable production costs with the cost of buying the product and select the lower-cost option.
In the second step we need to compare the avoidable 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 manufacturing 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.

19. Growth and the Level of Production
The decision to outsource would change if expected production increases from 2,000 to 3,000 units. Some avoidable costs are fixed relative to production, so cost per unit decreases as volume increases. If Premier outsources the 3,000 printers it will save $40,000 currently being spent on warehouse space.
Management will still reject the offer, but if growth is expected in the future it must be factored into management’s decision.
Part I The outsourcing decision may change if we expect increases in production. Some avoidable costs are fixed relative to production so the cost per unit decreases as volume increases. If Premier were to outsource 3000 printers it has been determined that $40,000 of warehouse space could be saved.
Part II Here we see the total of $690,300 could be avoided if we outsource 3000 printers.
Part III This would drop our average cost per unit avoided to $
Part IV
Management would still reject the offer because manufacturing is still the low-cost option. However, if production is expected to increase significantly in the future we must continually analyze this offer.
Cost per unit = $690,300 ÷ 3,000 = $230.10

20. Qualitative Features
A company that uses vertical integration controls the full range of activities from acquiring raw materials to distributing goods and services. An oil company, like Exxon, is a good example of vertical integration.
Outsourcing reduces the level of vertical integration, passing some of a company’s control over its production to outside suppliers.
A company that is vertically integrated controls the full range of activities from acquiring raw materials to distributing goods and services. An oil company like Exxon is a good example of vertical integration. The company is in the oil exploration business, the refining business, and the distribution of products to final consumers. When a vertically integrated company outsources, it passes some of its control to outside suppliers.

21. 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 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, a department, 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.

22. Should management eliminate the copier segment?
Here is detailed information about the three segments and the whole company. Notice 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 our 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?

23. 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 eliminate a business segment can be divided into three parts. In the first part we determine the amount of relevant revenue that pertains to eliminating 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.

24. Segment Elimination Decisions
Step 1: If Premier eliminates the copier segment, it will lose the $550,000 of revenue currently earned. 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.

25. Segment Elimination Decisions
Step 2: If Premier eliminates copiers, it will avoid the following costs:
In the second step we determine the costs 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.

26. Segment Elimination Decisions
Step 3: If Premier eliminates copiers, its profits will decrease:
If at we eliminate the copier segment overall profits will decrease by $62,000. Remember that the corporate level facilities sustaining costs will not be 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.

27. 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, and overall company profits had decreased by $62,000.

28. Qualitative Considerations
Employee lives will be disrupted.
Sales of different product lines are frequently interdependent.
What will happen to the space freed by the eliminated segment?
Volume changes can affect elimination decisions.

29. 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.

30. Equipment Replacement Decision
The equipment replacement decision should be based on profitability rather than physical deterioration. Consider the following: .

31. 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, It is a relevant cost.

32. Equipment Replacement Decision
The cost of the new machine can be avoided by keeping the old machine. 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. The operating expenses are relevant costs.
Let’s summarize the relevant costs for the two machines.

33. Equipment Replacement Decision
Our analysis shows 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). .

34. End of Chapter Four
In Chapter 4 we discussed many important concepts that managers are called upon to apply everyday. We hope that you have found many of these decisions interesting and that the analysis appears to be rational.