1. Relevant Costs for Decision Making Chapter 1 1

2. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 2 Cost Concepts for Decision Making A relevant cost is a cost that differs between alternatives. 1 2

3. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 3 Identifying Relevant Costs Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. Avoidable costs are relevant costs. Unavoidable costs are never relevant and include:  Sunk costs.  Future costs that do not differ between the alternatives.

4. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 4 Identifying Relevant Costs Sunk cost -- a cost that has already been incurred and that cannot be avoided regardless of what a manager decides to do.

5. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 5 Identifying Relevant Costs Well, I’ve assembled all the costs associated with the alternatives we are considering.

6. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 6 Identifying Relevant Costs Great! The first thing we need to do is eliminate all the sunk costs.

7. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 7 Quick Check In a decision of whether to buy a new car and trade-in 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.

8. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 8 Quick Check In a decision of whether to buy a new car and trade-in 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. Both of these costs have already been incurred and no decision now or in the future can change that fact.

9. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 9 Identifying Relevant Costs Now that we have eliminated the sunk costs, we need to eliminate the future costs that don’t differ between alternatives.

10. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 10 Quick Check In a decision of whether to buy a new car and trade-in 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.

11. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 11 Quick Check In a decision of whether to buy a new car and trade-in 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. 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.

12. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 12 Identifying Relevant Costs The decision will be easier now. All we have left are the avoidable costs.

13. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 13 Note Do not underestimate the importance and power of the relevant cost idea. Most costs (and benefits) do not differ between alternatives. This allows you to focus on the few things that matter. This principle also helps avoid mistakes.

14. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 14 Sunk Costs are not Relevant Costs Let’s look at the White Company example.

15. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 15 Sunk Costs are not Relevant Costs A manager at White Co. wants to replace an old machine with a new, more efficient machine.

16. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 16 Sunk Costs are not Relevant Costs White’s sales are $200,000 per year. Fixed expenses, other than depreciation, are $70,000 per year. Should the manager purchase the new machine?

17. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 17 Incorrect Analysis The manager recommends that the company not purchase the new machine since disposal of the old machine would result in a loss:

18. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 18 Correct Analysis Look at the comparative cost and revenue for the next five years. $200,000 per year × 5 years $100,000 per year × 5 years

19. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 19 Correct Analysis $70,000 per year × 5 years Look at the comparative cost and revenue for the next five years.

20. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 20 Correct Analysis The remaining book value of the old machine. The remaining book value of the old machine. Look at the comparative cost and revenue for the next five years.

21. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 21 Correct Analysis $80,000 per year × 5 years Look at the comparative cost and revenue for the next five years.

22. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 22 Correct Analysis Look at the comparative cost and revenue for the next five years. The total cost will be depreciated over the five year period.

23. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 23 Correct Analysis Look at the comparative cost and revenue for the next five years. The remaining book value of the old machine is a sunk cost and is not relevant to the decision. The remaining book value of the old machine is a sunk cost and is not relevant to the decision.

24. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 24 Correct Analysis Look at the comparative cost and revenue for the next five years. Would you recommend purchasing the new machine?

25. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 25 Relevant Cost Analysis Let’s look at a more efficient way to analyze this decision.

26. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 26 Relevant Cost Analysis Just focus on the costs that differ between alternatives.

27. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 27 Relevant Cost Analysis $100,000 - $80,000 = $20,000 variable cost savings

28. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 28 Relevant Cost Analysis

29. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 29 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. Let’s see how relevant costs should be used in this decision.

30. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 30 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.

31. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 31 Adding/Dropping Segments

32. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 32 Adding/Dropping Segments Investigation has revealed that total fixed general factory overhead and general administrative expenses would not be affected if the digital watch line is dropped. The fixed general factory overhead and general administrative expenses assigned to this product would be reallocated to other product lines. Investigation has revealed that total fixed general factory overhead and general administrative expenses would not be affected if the digital watch line is dropped. The fixed general factory overhead and general administrative expenses assigned to this product would be reallocated to other product lines.

33. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 33 Adding/Dropping Segments The equipment used to manufacture digital watches has no resale value or alternative use. The equipment used to manufacture digital watches has no resale value or alternative use. Should Lovell retain or drop the digital watch segment? Should Lovell retain or drop the digital watch segment?

34. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 34 A Contribution Margin Approach 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.

35. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 35 A Contribution Margin Approach

36. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 36 Comparative Income Approach 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 approach.

37. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 37 If the digital watch line is dropped, the company gives up its contribution margin.

38. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 38 On the other hand, the general factory overhead would be the same. So this cost really isn’t relevant.

39. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 39 But we wouldn’t need a manager for the product line anymore.

40. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 40 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.

41. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 41

42. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 42 Beware of Allocated Fixed Costs Why should we keep the digital watch segment when it’s showing a loss?

43. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 43 Beware of Allocated Fixed Costs The answer lies in the way we allocate common fixed costs to our products.

44. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 44 Beware of Allocated Fixed Costs Our allocations can make a segment look less profitable than it really is.

45. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 45 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.

46. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 46 The Make or Buy Decision Essex manufactures part 4A that is currently used in one of its products. The cost per unit of this part is:

47. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 47 The Make or Buy Decision The special equipment used to manufacture part 4A has no resale value. The total amount of general factory overhead, which is allocated on the basis of direct labor hours, would be unaffected by this decision. The $30 total cost per unit is based on 20,000 parts produced each year. Should we accept the supplier’s offer? 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?

48. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 48 The Make or Buy Decision 20,000 × $9 per unit = $180,000

49. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 49 The Make or Buy Decision The special equipment has no resale value and is a sunk cost.

50. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 50 The Make or Buy Decision Not avoidable and is irrelevant. If the product is dropped, it will be reallocated to other products.

51. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 51 The Make or Buy Decision Should we make or buy part 4A?

52. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 52 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.

53. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 53 The Matter of Opportunity Cost The benefits that are foregone as a result of pursuing some course of action. Opportunity costs are not actual dollar outlays and are not recorded in the accounts of an organization.

54. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 54 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.

55. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 55 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.

56. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 56 Special Orders Jet, Inc. makes a single product whose normal selling price is $20 per unit. A foreign distributor offers to purchase 3,000 units for $10 per unit. This is a one-time order that would not affect the company’s regular business. Annual capacity is 10,000 units, but Jet, Inc. is currently producing and selling only 5,000 units. Should Jet accept the offer?

57. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 57 Special Orders $8 variable cost

58. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 58 Special Orders If Jet accepts the offer, net income will increase by $6,000. Note: This answer assumes that fixed costs are unaffected by the order and that variable marketing costs must be incurred on the special order.

59. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 59 Quick Check Northern Optical ordinarily sells the X-lens for $50. The variable production cost is $10, the fixed production cost is $18 per unit, and the variable selling cost is $1. A customer has requested a special order for 10,000 units of the X-lens to be imprinted with the customer’s logo. This special order would not involve any selling costs, but Northern Optical would have to purchase an imprinting machine for $50,000. (see the next page)

60. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 60 Quick Check What is the rock bottom minimum price below which Northern Optical should not go in its negotiations with the customer? In other words, below what price would Northern Optical actually be losing money on the sale? There is ample idle capacity to fulfill the order. a. $50 b. $10 c. $15 d. $29

61. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 61 Quick Check What is the rock bottom minimum price below which Northern Optical should not go in its negotiations with the customer? In other words, below what price would Northern Optical actually be losing money on the sale? There is ample idle capacity to fulfill the order. a. $50 b. $10 c. $15 d. $29 Variable production cost $100,000 Additional fixed cost 50,000 Total relevant cost$150,000 Number of units 10,000 Average cost per unit $15

62. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 62 Utilization of a Constrained Resource Firms often face the problem of deciding how to best utilize a constrained resource. Usually fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin. Let’s look at the Ensign Company example.

63. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 63 Utilization of a Constrained Resource Ensign Company produces two products and selected data is shown below:

64. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 64 Utilization of a Constrained Resource Machine A1 is the constrained resource and is being used at 100% of its capacity. There is excess capacity on all other machines. Machine A1 has a capacity of 2,400 minutes per week. Should Ensign focus its efforts on Product 1 or 2?

65. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 65 Quick Check How many units of each product can be processed through Machine A1 in one minute? Product 1 Product 2 a. 1 unit 0.5 unit b. 1 unit 2 units c. 2 units 1 unit d. 2 units 0.5 unit

66. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 66 Quick Check How many units of each product can be processed through Machine A1 in one minute? Product 1 Product 2 a. 1 unit 0.5 unit b. 1 unit 2 units c. 2 units 1 unit d. 2 units 0.5 unit I was just checking to make sure you are awake.

67. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 67 Quick Check What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2? a. Product 1 b. Product 2 c. They both would generate the same profit d. Cannot be determined

68. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 68 Quick Check What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2? a. Product 1 b. Product 2 c. They both would generate the same profit d. Cannot be determined With one minute of machine A1, we could make 1 unit of Product 1, with a contribution margin of $24, or 2 units of Product 2, each with a contribution margin of $15. 2 × $15 > $24

69. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 69 Utilization of a Constrained Resource The key is the contribution margin per unit of the constrained resource. Product 2 should be emphasized. Provides more valuable use of the constrained resource machine A1, yielding a contribution margin of $30 per minute as opposed to $24 for Product 1.

70. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 70 Utilization of a Constrained Resource If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use remaining capacity to make Product 1.

71. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 71 Utilization of a Constrained Resource Let’s see how this plan would work.

72. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 72 Utilization of a Constrained Resource Let’s see how this plan would work.

73. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 73 Utilization of a Constrained Resource Let’s see how this plan would work.

74. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 74 Utilization of a Constrained Resource According to the plan, we will produce 2,200 units of Product 2 and 1,300 of Product 1. Our contribution margin looks like this. The total contribution margin for Ensign is $64,200.

75. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 75 Quick Check Colonial Heritage makes reproduction colonial furniture from select hardwoods. The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand? a. Yes b. No

76. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 76 Quick Check Colonial Heritage makes reproduction colonial furniture from select hardwoods. The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand? a. Yes b. No 2  600 + 10  100 = 2,200 > 2,000

77. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 77 Quick Check The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits? a. 500 chairs and 100 tables b. 600 chairs and 80 tables c. 500 chairs and 80 tables d. 600 chairs and 100 tables

78. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 78 Quick Check The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits? a. 500 chairs and 100 tables b. 600 chairs and 80 tables c. 500 chairs and 80 tables d. 600 chairs and 100 tables

79. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 79 Quick Check As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood? a. $40 per board foot b. $25 per board foot c. $20 per board foot d. Zero

80. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 80 Quick Check As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood? a. $40 per board foot b. $25 per board foot c. $20 per board foot d. Zero The additional wood would be used to make tables. In this use, each board foot of additional wood will allow the company to earn an additional $20 of contribution margin and profit.

81. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 81 Quick Check As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume there is unlimited demand for chairs. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood? a. $40 per board foot b. $25 per board foot c. $20 per board foot d. Zero

82. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 82 Quick Check As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume there is unlimited demand for chairs. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood? a. $40 per board foot b. $25 per board foot c. $20 per board foot d. Zero Since there is unlimited demand for chairs and chairs are a more valuable use of wood than tables, all of the additional wood would presumably be used to produce chairs. In this use, each board foot of additional wood will allow the company to earn an additional $25 of contribution margin and profit.

83. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 83 Managing Constraints Finding ways to process more units through a resource bottleneck Produce only what can be sold. Streamline production process. Eliminate waste. At the bottleneck itself: Improve the process Add overtime or another shift Hire new workers or acquired more machines Subcontract production

84. © The McGraw-Hill Companies, Inc., 2002 Irwin/McGraw-Hill 84 End of Chapter 11