2. 9 - 1 © 2005 Accounting 1/e, Terrell/Terrell Using Relevant Information for Internal Operations Chapter 9

3. 9 - 2 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 1 Determine the fixed and variable components of a cost element using the high-low method and results of regression analysis.

4. 9 - 3 © 2005 Accounting 1/e, Terrell/Terrell Fixed and Variable Components of a Cost Element Understanding the company’s cost components and determining cost formulas are a basic analysis techniques for planning and budgeting.

5. 9 - 4 © 2005 Accounting 1/e, Terrell/Terrell Using the High-Low Method to Find the Total Cost Formula TC = FC + (UVC × V) Total Cost = Fixed costs + (Unit variable cost × Volume) The high-low method is a model that separates the fixed and variable components of a cost element.

6. 9 - 5 © 2005 Accounting 1/e, Terrell/Terrell Bicycle Shop Example 199819992000200120025,4005,2005,0006,0006,400$432,000 416,000 416,000 400,000 400,000 480,000 480,000 512,000 512,000$30,000 33,000 33,000 32,000 32,000 35,000 35,000 38,000 38,000YearUnitssold Cost of goods sold Storesupplies Low High

7. 9 - 6 © 2005 Accounting 1/e, Terrell/Terrell Bicycle Shop Example High High Low Low Difference Difference6,4005,0001,400$512,000 400,000 400,000$112,000Unitssold Cost of goods sold Step 1: Step 2: $112,000 ÷ 1,400 = $80 variable cost per unit sold

8. 9 - 7 © 2005 Accounting 1/e, Terrell/Terrell Bicycle Shop Example High High Low Low Difference Difference6,4005,0001,400$38,000 32,000 32,000 $ 6,000 Unitssold Cost of goods sold Step 1: Step 2: $6,000 ÷ 1,400 = $4.2857 variable cost per unit sold

9. 9 - 8 © 2005 Accounting 1/e, Terrell/Terrell Bicycle Shop Example TC = $22,571.52 + ($84.2857 × Units sold) Fixed cost Rent Cost of goods sold Store supplies Total$12,000.00 0.00 0.00 10,571.52 10,571.52$22,571.52 $ 0.0000 80.0000 80.0000 4.2857 4.2857$84.2857UnitvariablecostExpense

10. 9 - 9 © 2005 Accounting 1/e, Terrell/Terrell Bicycle Shop Example If management predicts it will sell 5,800 units in 200X, what would the formula predict the cost to be? TC = $22,571.52 + ($84.2857 × 5,800) Rent$ 12,000.00 Cost of goods sold 464,000.00 Store supplies 35,428.58 Total costs$511,428.58

11. 9 - 10 © 2005 Accounting 1/e, Terrell/Terrell Learning Objectives 2 and 3 Identify the characteristics of a relevant cost or revenue. Demonstrate why sunk costs and costs that do not differ between alternatives are irrelevant costs.

12. 9 - 11 © 2005 Accounting 1/e, Terrell/Terrell Relevant versus Irrelevant Concepts Relevant costing is the process of determining which dollar inflows and outflows pertain to a particular management decision. Sunk costs are past costs that cannot be changed by current or future actions. A relevant cost is a future cost that is pertinent to a particular decision and differs between decision alternatives.

13. 9 - 12 © 2005 Accounting 1/e, Terrell/Terrell Relevant versus Irrelevant Concepts A relevant cost must differ between alternatives. If a cost remains the same regardless of the decision alternative, it is irrelevant. A relevant revenue is a future revenue that differs between alternatives. Relevant costs and revenues are quantitative factors that affect business decisions.

14. 9 - 13 © 2005 Accounting 1/e, Terrell/Terrell Decision Model to Determine Relevant Costs and Revenues Is the item a future cost or revenue? Does the cost or revenue differ between decision alternatives? Yes The cost or revenue IS relevant. Yes The cost or revenue is NOT relevant. No The cost or revenue is NOT relevant. No

15. 9 - 14 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 4 Discuss several major qualitative factors that should be considered when making a business decision.

16. 9 - 15 © 2005 Accounting 1/e, Terrell/Terrell Qualitative Factors These are non-numerical attributes that will affect decision alternatives. Product quality Employee morale Customer perceptions Customer satisfaction

17. 9 - 16 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 5 Use accounting information to determine the relevant cost of various decisions.

18. 9 - 17 © 2005 Accounting 1/e, Terrell/Terrell Equipment Replacement – Gather all Decision Information Elevation Sports, Inc.’s production equipment is three years old. Its cost was $75,000 with a residual value of $15,000 and an estimated remaining life of five years. Operators expenses are $50,000 per year. Maintenance is $3,000 per year.

19. 9 - 18 © 2005 Accounting 1/e, Terrell/Terrell Equipment Replacement – Gather all Decision Information The new equipment will cost $100,000. It has an estimated useful life of five years with a $10,000 residual value. Expenses for one operator are $30,000 per year and maintenance is $1,500 per year. Equipment can be sold now for $20,000.

20. 9 - 19 © 2005 Accounting 1/e, Terrell/Terrell Replacement Cost Summary Oldequipment New Newequipment Start-up costs: Cost of equipment$ 75,000$100,000 Operating costs: Annual depreciation$ 12,000$ 18,000 Total depreciation – 5 years 60,000 90,000 Annual labor cost 50,000 30,000 Total labor cost – 5 years 250,000 150,000 Annual maintenance cost 3,000 1,500 Total maintenance cost – 5 years 15,000 10,000 Shutdown costs: Residual value of equipment$ 15,000$ 10,000 Current sale price old equipment 20,000

21. 9 - 20 © 2005 Accounting 1/e, Terrell/Terrell Relevant Cost of Each Alternative Relevant: Total labor cost$250,000 Maintenance$ 15,000 Residual value$ 15,000 Current sale price$ 20,000 Irrelevant: Cost of system$ 75,000 Depreciation$ 60,000

22. 9 - 21 © 2005 Accounting 1/e, Terrell/Terrell Relevant Cost of Each Alternative Relevant: Cost of equipment$100,000 Total labor cost$150,000 Maintenance$ 7,500 Residual value$ 10,000 Irrelevant: Depreciation$ 90,000

23. 9 - 22 © 2005 Accounting 1/e, Terrell/Terrell Replacement Cost Comparison $22,500 in favor of buying the new equipment Start-up costs: Cost of new equipment$(100,000) Operating costs: Labor cost:$(250,000) (150,000) Maintenance cost: (15,000) ( 7,500) Maintenance cost: (15,000) ( 7,500) Shutdown costs: Residual value of old equipment 15,000 Sale price of old equipment sold now 20,000 Residual value of new equipment 10,000 Total relevant costs$(250,000)$(227,500) Keep old equipment Replace old equipment

24. 9 - 23 © 2005 Accounting 1/e, Terrell/Terrell Special Orders A special order is outside the normal scope of business activity. A representative of a Swiss ski resort approaches Elevation Sports, Inc., with a proposition to purchase 2,000 snowboards for $70 each. The normal wholesale price is $95 per board. Should Elevation Sports, Inc., accept this order?

25. 9 - 24 © 2005 Accounting 1/e, Terrell/Terrell Gather Relevant Information Expected wholesale sales (5,000 units @ $95 each)$475,000 Less: Cost of goods sold 350,000 Expected gross margin$125,000 Number of units 1 5,000 Direct material costs$10$ 50,000 Direct labor costs 25 125,000 Variable production costs 15 75,000 Fixed production costs 20 100,000 Total cost of goods sold$70$350,000 Per unit Total Detailed calculation for cost of goods sold

26. 9 - 25 © 2005 Accounting 1/e, Terrell/Terrell Gather Relevant Information Sales from special order$70$140,000 Direct material costs$10$ 20,000 Direct labor costs 25 50,000 Variable production costs 15 30,000 Total relevant production costs$50$100,000 Total increase in income$20$ 20,000 Per unit Total Relevant costs for special order of 2,000 snowboards

27. 9 - 26 © 2005 Accounting 1/e, Terrell/Terrell Make or Buy Decisions Outsourcing is buying services, products, or components of products from outside vendors instead of producing them. Elevation Sports, Inc., has always purchased its binding from a vendor. The vendor has now indicated that the price will increase from $5.00 each to $7.00. Is it cheaper to manufacture the binding?

28. 9 - 27 © 2005 Accounting 1/e, Terrell/Terrell Gather Relevant Information Direct material$3.00$30,000 Direct labor 1.00 10,000 Variable overhead 0.50 5,000 Fixed overhead 0.40 4,000 Total costs$4.90 $49,000 Cost per unit Total cost for 10,000 units

29. 9 - 28 © 2005 Accounting 1/e, Terrell/Terrell Selecting Relevant Costs Direct labor yesyesyes Variablemanufacturingoverheadyesyesyes Fixedoverhead: new machine yesyesyes Direct material yesyesyesFuture?Differs?Relevant?

30. 9 - 29 © 2005 Accounting 1/e, Terrell/Terrell Relevant Cost of Make or Buy Decisions for Bindings $21,000 in favor of making the bindings Cost to purchase (10,000 × $7)$70,000 Direct material$30,000 Direct labor 10,000 Variable overhead 5,000 Fixed overhead 4,000 Total relevant costs$49,000$70,000 MakeBuy

31. 9 - 30 © 2005 Accounting 1/e, Terrell/Terrell Relevant Cost of Make or Buy Decisions for Bindings $21,000 in favor of making the bindings Cost to purchase (10,000 × $7)$70,000 Direct material$30,000 Direct labor 10,000 Variable overhead 5,000 Additional fixed overhead 4,000 Fixed overhead 15,000 15,000 Total relevant costs$64,000$85,000 MakeBuy

32. 9 - 31 © 2005 Accounting 1/e, Terrell/Terrell Learning Objective 6 Interpret the effects of fixed costs and opportunity costs on various decisions.

33. 9 - 32 © 2005 Accounting 1/e, Terrell/Terrell Special Relevant Cost Considerations for Fixed Costs Fixed costs normally are irrelevant in make or by decisions. Costs which can change Costs which cannot change

34. 9 - 33 © 2005 Accounting 1/e, Terrell/Terrell Decision to Outsource Services Fast Track Delivery Service operates a small auto repair facility. Fast Track is considering using a local CPA firm to prepare the weekly payroll. It currently pays $1,500 per week plus benefits and payroll taxes of $525 per week. Weekly administrative costs of $1,000 per week will not change.

35. 9 - 34 © 2005 Accounting 1/e, Terrell/Terrell Decision to Outsource Services The CPA firm has offered to provide the services for $2,000 per week. If Fast Track accepts the offer, they could reduce the weekly wages by $1,250, benefits by $450, and save supplies costs of $125 per week.

36. 9 - 35 © 2005 Accounting 1/e, Terrell/Terrell Relevant Costs for Each Alternative Salary costs$1,500$ 250 Benefits and payroll taxes 525 2,000 Costs of CPA firm 125 0 Total relevant costs$2,150$2,325 Continuein-houseOutsource

37. 9 - 36 © 2005 Accounting 1/e, Terrell/Terrell Decision to Add or Close Divisions When a firm has excess capacity, expanding to produce new product lines or adding new divisions can be profitable because the firm does not have to add fixed costs. As long as a product or division is producing contribution margin toward unavoidable fixed costs, it is usually more profitable to continue.

38. 9 - 37 © 2005 Accounting 1/e, Terrell/Terrell Decision to Add or Close Divisions Austin Products has three product lines, A, B, and C that it considers losers. Unavoidable fixed costs$130,000$ 50,000$250,000 Decision choiceContinue CloseContinue Current loss$110,000$ 130,000$100,000

39. 9 - 38 © 2005 Accounting 1/e, Terrell/Terrell Mountain Boards Example Elevation Sports, Inc. is considering manufacturing and selling mountain boards. Potential sales price per unit: Wholesale$120 Retail 200

40. 9 - 39 © 2005 Accounting 1/e, Terrell/Terrell Mountain Boards Example Variable costs per unit: Materials$30 Materials$30 Labor 20 Labor 20 Variable overhead 30 Variable overhead 30 Total variable cost per unit$80 Allocated unavoidable fixed costs (part of current fixed costs)20,000 (part of current fixed costs)20,000 Added new fixed costs 3,000

41. 9 - 40 © 2005 Accounting 1/e, Terrell/Terrell Mountain Boards Example: Assumptions Retail sales: (1) BE Units =FCUCM= 192 units =$23,000 $200 – $80 (2) BE Units =FCUCM= 25 units 25 units=$3,000 $200 – $80

42. 9 - 41 © 2005 Accounting 1/e, Terrell/Terrell Mountain Boards Example: Assumptions Wholesale sales: (1) BE Units =FCUCM= 576 units =$23,000 $120 – $80 (2) BE Units =FCUCM= 75 units 75 units=$3,000 $120 – $80

43. 9 - 42 © 2005 Accounting 1/e, Terrell/Terrell Mountain Boards Example: Schedule (A) $120 wholesale price × 576 units = $69,120 (B) $200 retail price × units = $5,000 Added sales (A) (B)$69,120$5,000 Additional variable costs 46,080 2,000 Additional contribution margin$23,040$3,000 Added fixed costs 3,000 3,000 Addition to net income$20,040$ -0- WorstcaseBestcase

44. 9 - 43 © 2005 Accounting 1/e, Terrell/Terrell Considering Opportunity Costs An opportunity cost is the value of what is given up because of choosing one alternative over another. Assume that Elevation Sports, Inc., can use its excess capacity to make the bindings or produce mountain boards, but not both. The officers believe that they can sell at least 200 mountain boards.

45. 9 - 44 © 2005 Accounting 1/e, Terrell/Terrell Considering Opportunity Costs Sales ($200 × 200)$40,000 Less:Variable costs ($80 × 200) (16,000) Added Fixed Costs (3,000) Net Contribution Margin$21,000 What is the contribution margin of the 200 boards at retail prices?

46. 9 - 45 © 2005 Accounting 1/e, Terrell/Terrell Relevant Cost of Make or Buy Decisions for Bindings Difference = $0 Cost to purchase (10,000 × $7)$70,000 Direct material$30,000 Direct labor 10,000 Variable overhead 5,000 Fixed overhead 4,000 Opportunity costs 21,000 Total relevant costs$70,000$70,000 MakeBuy

47. 9 - 46 © 2005 Accounting 1/e, Terrell/Terrell Appendix Regression analysis is a mathematical model that uses all the items in the data set to compute a least-squares regression line that equals the total cost formula. Y = total costs a = fixed costs b = unit variable cost X = the activity level

48. 9 - 47 © 2005 Accounting 1/e, Terrell/Terrell End of Chapter 9