1 chapter m6 making decisions using relevant information © 2007 pearson custom publishing

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CHAPTER M6CHAPTER M6

Making Decisions Making Decisions UsingUsing

Relevant Relevant InformationInformation

© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Learning Objective Learning Objective 1:1:

Identify the Identify the characteristics of a characteristics of a

relevant cost.relevant cost.


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Relevant CostingRelevant Costing Internal decision makers are faced with Internal decision makers are faced with

tough decisions on a regular basis. When tough decisions on a regular basis. When faced with a financial decision, managers faced with a financial decision, managers are often overwhelmed by a mountain of are often overwhelmed by a mountain of information.information.

Relevant costingRelevant costing is the process of is the process of determining which pieces of information determining which pieces of information are relevant to the decision at hand.are relevant to the decision at hand.


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Relevant CostsRelevant Costs Costs can be accumulated for any imaginable Costs can be accumulated for any imaginable

reason. Relevant costs are those costs (and reason. Relevant costs are those costs (and revenues) that need to be considered because revenues) that need to be considered because they have an impact on a particular decision.they have an impact on a particular decision.

A factor that is relevant to one manager may A factor that is relevant to one manager may not be relevant to the next. A factor that is not be relevant to the next. A factor that is relevant to one decision may not be relevant to relevant to one decision may not be relevant to the next.the next.


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Determining Determining Relevant CostsRelevant Costs

To be relevant to a management decision, To be relevant to a management decision, information must possessinformation must possess BOTHBOTH of these of these characteristics:characteristics: it must be a future cost or revenue, andit must be a future cost or revenue, and it must differ between decision alternatives.it must differ between decision alternatives.

Reasoned decision makers use only relevant Reasoned decision makers use only relevant information when making an economic information when making an economic decision.decision.


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Explain why sunk Explain why sunk costs and costs that costs and costs that

do not differ between do not differ between alternatives are alternatives are irrelevant costs.irrelevant costs.


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Sunk CostSunk Cost

A A sunk costsunk cost is a past cost that cannot be is a past cost that cannot be changed by current or future actions.changed by current or future actions.

Examples of sunk costs:Examples of sunk costs: Equipment, land, or buildings purchased in Equipment, land, or buildings purchased in

the pastthe past Equipment leased on a long-term leaseEquipment leased on a long-term lease New vehicle purchased and usedNew vehicle purchased and used One-year old computer equipmentOne-year old computer equipment


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Irrelevant Irrelevant InformationInformation

We should identify irrelevant information We should identify irrelevant information and NOT use it in our analysis. Irrelevant and NOT use it in our analysis. Irrelevant information possesses either of the information possesses either of the following characteristics:following characteristics: it is a sunk cost or revenue, orit is a sunk cost or revenue, or it does not differ between alternatives.it does not differ between alternatives.

A manager should filter out all irrelevant A manager should filter out all irrelevant information before making a decision.information before making a decision.


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Describe the Describe the qualitative factors qualitative factors

that should be that should be considered when considered when

making a business making a business decision.decision.


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Quantitative or Quantitative or Qualitative Factors?Qualitative Factors?

Quantitative factorsQuantitative factors can be expressed as can be expressed as a number. a number. Qualitative factorsQualitative factors cannot be cannot be expressed numerically and must be expressed numerically and must be described in words.described in words.

Most management decisions require the Most management decisions require the consideration of both quantitative and consideration of both quantitative and qualitative factors.qualitative factors.


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Quantitative or Quantitative or Qualitative Factors?Qualitative Factors? Consider that management wants to purchase Consider that management wants to purchase

a new copier.a new copier. Quantitative factorsQuantitative factors include: include:

Cost of the machineCost of the machine Cost of machine maintenanceCost of machine maintenance Cost per copy of suppliesCost per copy of supplies

Qualitative factorsQualitative factors include: include: Ease of operationEase of operation Quality of copies madeQuality of copies made Change in environment for users (noise, heat, etc.)Change in environment for users (noise, heat, etc.)


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Use accounting Use accounting information and information and determine the determine the

relevant cost of relevant cost of various decisions.various decisions.


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Relevant Cost Relevant Cost Decision MakingDecision Making

When making a relevant cost decision, follow When making a relevant cost decision, follow these steps in the process:these steps in the process: Gather all costs associated with the decision.Gather all costs associated with the decision. Determine the relevant cost of each alternative.Determine the relevant cost of each alternative. Compare relevant costs and select an Compare relevant costs and select an

alternative.alternative.


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Equipment ReplacementEquipment Replacement Managers are often faced with the Managers are often faced with the

decision to replace equipment or other decision to replace equipment or other long-term assets. This is actually a long-term assets. This is actually a complicated decision with many complicated decision with many uncontrollable factors, such as the rate of uncontrollable factors, such as the rate of technological change.technological change.

We will look at the basics of the We will look at the basics of the replacement decision from a relevant cost replacement decision from a relevant cost perspective.perspective.


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Associated CostsAssociated Costs We need to gather all relevant costs related to We need to gather all relevant costs related to

the equipment replacement decision. Any the equipment replacement decision. Any differential costs to be incurred in the future differential costs to be incurred in the future would be relevant. Possible examples include would be relevant. Possible examples include start-up costs, operating costs, and shutdown start-up costs, operating costs, and shutdown costs.costs.

Irrelevant costs will include the original and Irrelevant costs will include the original and current book values of the old equipment, current book values of the old equipment, and all depreciation charges.and all depreciation charges.


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Replacement Replacement ExampleExample

Company AYZ is considering the Company AYZ is considering the replacement of an old computer system replacement of an old computer system with a new one. One with a new one. One qualitativequalitative factor to factor to consider is the fact that the new computer consider is the fact that the new computer will allow them to do various new computing will allow them to do various new computing tasks not possible with the old computer.tasks not possible with the old computer.

Let’s review the quantitative information.Let’s review the quantitative information.


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Quantitative Cost Quantitative Cost SummarySummary

OldComputer

NewComputer

Start-up costs:Cost to purchase 10,000$ 14,000$

Operating costs:Annual depreciation 1,500$ 4,000$ Total depreciation 9,000 12,000 Annual labor cost 20,000 20,000 Annual maintenance cost 4,000 2,500

Shutdown costs:Residual value at end of life 1,000$ 2,500$ Sales value of old computer 4,000 N/A

Remaining useful life 3 years 3 years


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Determine Relevant Determine Relevant Costs of Keeping Old Costs of Keeping Old

ComputerComputer Cost to purchase: irrelevant (sunk)Cost to purchase: irrelevant (sunk) Annual depreciation: irrelevant (repeat item)Annual depreciation: irrelevant (repeat item) Total depreciation: irrelevant (repeat item)Total depreciation: irrelevant (repeat item) Annual labor cost: irrelevant (no difference)Annual labor cost: irrelevant (no difference) Maintenance cost: relevant (differential)Maintenance cost: relevant (differential) Residual value: relevant (differential)Residual value: relevant (differential) Current sales value: relevant (future inflow)Current sales value: relevant (future inflow)


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Determine Relevant Determine Relevant Costs of Buying New Costs of Buying New

ComputerComputer Cost to purchase: relevant (future outlay)Cost to purchase: relevant (future outlay) Annual depreciation: irrelevant (repeat item)Annual depreciation: irrelevant (repeat item) Total depreciation: irrelevant (repeat item)Total depreciation: irrelevant (repeat item) Annual labor cost: irrelevant (no difference)Annual labor cost: irrelevant (no difference) Maintenance cost: relevant (differential)Maintenance cost: relevant (differential) Residual value: relevant (differential)Residual value: relevant (differential)

NOTE: this analysis ignores the income tax NOTE: this analysis ignores the income tax implications of the replacement decision.implications of the replacement decision.


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Relevant Cost Relevant Cost ComparisonComparison

Keep OldComputer

Buy NewComputer

Start-up costs:Cost to purchase (14,000)$

Operating costs:Maintenance cost (3 years) (12,000) (7,500)

Shutdown costs:Residual value at end of life 1,000$ 2,500$ Sales value of old computer 4,000

(11,000) (15,000)

Difference in relevant costs $4,000Benefit to keep old.


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Cost to Replace Cost to Replace ComputerComputer

The relevant cost analysis indicates a The relevant cost analysis indicates a $4,000 cost savings in favor of keeping $4,000 cost savings in favor of keeping the old computer system. This analysis the old computer system. This analysis is based on quantitative factors only.is based on quantitative factors only.

Keep in mind that the new computer Keep in mind that the new computer will allow AYZ to do various new will allow AYZ to do various new computer tasks. They will analyze computer tasks. They will analyze these added benefits in light of the these added benefits in light of the $4,000 cost. $4,000 cost.


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Discussion QuestionsDiscussion Questions

Consider a slightly different Consider a slightly different computer replacement decision. computer replacement decision. Would your analysis change if you Would your analysis change if you had purchased the old computer one had purchased the old computer one year ago instead of six years ago?year ago instead of six years ago?

Would your analysis change if you Would your analysis change if you bought the old computer one month bought the old computer one month ago? What about one week ago?ago? What about one week ago?


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Time Value of MoneyTime Value of Money

Whenever long-term cash flows are Whenever long-term cash flows are being considered, the being considered, the time value of time value of moneymoney should be factored into the should be factored into the analysis. We will consider this analysis. We will consider this factor in the next chapter.factor in the next chapter.

The time value of money recognizes The time value of money recognizes that a dollar received or spent in the that a dollar received or spent in the future is not equal to a dollar future is not equal to a dollar received or spent today.received or spent today.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Special Order DecisionsSpecial Order Decisions

A manufacturing company is A manufacturing company is sometimes presented with a sometimes presented with a special special order.order. Such an order usually Such an order usually includes a discounted price for the includes a discounted price for the items being ordered.items being ordered.

The manufacturer must decide The manufacturer must decide whether to accept or reject the whether to accept or reject the special order.special order.


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Special Order Special Order Factors to ConsiderFactors to Consider

Quantitative factors to consider include:Quantitative factors to consider include: relevant manufacturing costs of the items,relevant manufacturing costs of the items, relevant selling/distribution costs of the items,relevant selling/distribution costs of the items, selling price to be paid by the customer, andselling price to be paid by the customer, and impact (if any) on regular sales volume.impact (if any) on regular sales volume.

Qualitative factors may include the effect Qualitative factors may include the effect on the workforce (avoid layoffs?), on the workforce (avoid layoffs?), competitive considerations, and prospects competitive considerations, and prospects of future deals.of future deals.


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Sample Data - Without Sample Data - Without Special OrderSpecial Order

The CBA Company Per Unit TotalUnits produced and sold 1 5,000

Normal selling price per unit 140.00$ 700,000$

Direct materials cost 20.00 100,000 Direct labor cost 15.00 75,000 Variable overhead cost 10.00 50,000 Fixed overhead cost 30.00 150,000 Variable selling cost 5.00 25,000 Fixed selling cost 20.00 100,000

Total costs 100.00$ 500,000$


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Special Order ExampleSpecial Order Example

Assume that the CBA Company has Assume that the CBA Company has received a special order for 1,000 units received a special order for 1,000 units at a price of $80 per unit. Accepting at a price of $80 per unit. Accepting this special order will not have any this special order will not have any impact on CBAs normal sales volume.impact on CBAs normal sales volume.

At first glance, the order appears to be At first glance, the order appears to be an unacceptable offer. The special an unacceptable offer. The special price is below the normal cost per unit price is below the normal cost per unit of $100.of $100.


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Associated CostsAssociated Costs

The first step is to gather all of the The first step is to gather all of the associated costs and other pieces of associated costs and other pieces of financial information. This financial information. This information was already presented information was already presented for the CBA Company.for the CBA Company.

The second step is to determine The second step is to determine which costs are relevant to the which costs are relevant to the decision to accept the special order.decision to accept the special order.


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Determine Relevant Determine Relevant CostsCosts

To be relevant to this special order, To be relevant to this special order, a cost has to differ between the a cost has to differ between the accept and reject alternatives.accept and reject alternatives.

Unless total fixed costs are going to Unless total fixed costs are going to increase with the increased increase with the increased production of the special order units, production of the special order units, all fixed costs are irrelevant to this all fixed costs are irrelevant to this decision.decision.


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Unless stated otherwise, all variable Unless stated otherwise, all variable costs will be relevant to accepting the costs will be relevant to accepting the order.order.

By definition, total variable costs By definition, total variable costs increase as volume increases. Thus, increase as volume increases. Thus, there will be 1,000 additional units there will be 1,000 additional units manufactured and sold during this manufactured and sold during this period, with a proportionate increase in period, with a proportionate increase in the amount of variable costs incurred.the amount of variable costs incurred.


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The CBA Company Per Unit TotalSpecial order units 1 1,000

Special selling price per unit 80.00$ 80,000$

Relevant costs:Direct materials cost 20.00 20,000 Direct labor cost 15.00 15,000 Variable overhead cost 10.00 10,000 Variable selling cost 5.00 5,000

Total costs 50.00$ 50,000$

Additional profit margin 30.00$ 30,000$

© 2007 Pearson Custom © 2007 Pearson Custom PublishingPublishing

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Special Order Final Special Order Final AnalysisAnalysis

Although the special order price is Although the special order price is below the normal full cost per unit, the below the normal full cost per unit, the CBA Company can experience a CBA Company can experience a $30,000 increase in operating profit this $30,000 increase in operating profit this period by accepting the special order.period by accepting the special order.

In some special order situations, the In some special order situations, the variable selling costs might not be variable selling costs might not be relevant if they will be avoided on the relevant if they will be avoided on the extra units.extra units.


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Can you give an example of a Can you give an example of a situation where accepting a special situation where accepting a special order could have a negative impact order could have a negative impact on your regular sales volume?on your regular sales volume?

Can you give an example of a Can you give an example of a situation where the variable selling situation where the variable selling costs would not be relevant to a costs would not be relevant to a special order decision?special order decision?


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Make or Buy DecisionMake or Buy Decision

Some companies purchase certain Some companies purchase certain products or parts instead of products or parts instead of manufacturing them. Each product manufacturing them. Each product or part represents a separate or part represents a separate make make or buy decision.or buy decision.

When a company chooses to When a company chooses to purchase a service, product, or part purchase a service, product, or part from an outside vendor, it is called from an outside vendor, it is called outsourcing.outsourcing.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Associated CostsAssociated Costs

We first need to gather information We first need to gather information about all related costs. This includes about all related costs. This includes all costs to manufacture the item as all costs to manufacture the item as well as the cost to purchase the item.well as the cost to purchase the item.

Other obvious considerations include Other obvious considerations include control over the quality of the product, control over the quality of the product, and availability of the item in the and availability of the item in the quantities needed on a timely basis. quantities needed on a timely basis.


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Make or Buy ExampleMake or Buy Example

The EFG Company currently The EFG Company currently manufactures all of the parts used in manufactures all of the parts used in the production of remote control toy the production of remote control toy cars.cars.

They have been approached by another They have been approached by another company that has offered to supply the company that has offered to supply the remote control device at a cost of remote control device at a cost of $5.50 per unit. Quality and availability $5.50 per unit. Quality and availability of the controls is not an issue.of the controls is not an issue.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Make or Buy ExampleMake or Buy Example

The EFG CompanyPer Unit Total

Units currently manufactured 1 30,000

Manufacturing costs:Direct materials cost 2.50$ 75,000$ Direct labor cost 1.50 45,000 Variable overhead cost 1.00 30,000 Fixed overhead cost 2.00 60,000

Total costs 7.00$ 210,000$


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Relevant costs for the “make” Relevant costs for the “make” alternative include only those future, alternative include only those future, differential production costs. By differential production costs. By definition, all future variable production definition, all future variable production costs will be relevant.costs will be relevant.

Fixed production costs stay constant in Fixed production costs stay constant in total regardless of the amount of total regardless of the amount of production activity. Therefore, the fixed production activity. Therefore, the fixed overhead cost allocated to this unit is overhead cost allocated to this unit is irrelevant.irrelevant.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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The relevant costs of the The relevant costs of the “buy” alternative are easy “buy” alternative are easy to determine. If the to determine. If the supplier charges $5.50 per supplier charges $5.50 per unit, and if there are no unit, and if there are no “hidden” or additional “hidden” or additional charges, then that amount charges, then that amount represents the only represents the only relevant cost to buy the relevant cost to buy the controls.controls.


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The EFG CompanyMake Buy

Units needed 30,000 30,000

Total relevant cost:Cost to purchase ($5.50 each) 165,000$ Direct materials cost 75,000$ Direct labor cost 45,000 Variable overhead cost 30,000

Total relevant cost 150,000$ 165,000$

Difference in relevant costs $15,000difference in favor

of making the controls


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Changes in Fixed CostsChanges in Fixed Costs

In some situations, there may be some In some situations, there may be some fixed manufacturing costs that are fixed manufacturing costs that are relevant. relevant.

It is possible that there could be an It is possible that there could be an increase in the total fixed overhead increase in the total fixed overhead costs if a special order was accepted.costs if a special order was accepted.

It is also possible that total fixed costs It is also possible that total fixed costs could decrease if we purchased rather could decrease if we purchased rather than manufactured a particular item.than manufactured a particular item.


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Changes in Fixed CostsChanges in Fixed Costs

Let’s continue with the make or buy Let’s continue with the make or buy example and add one more fact. Assume example and add one more fact. Assume that the EFG Company would experience that the EFG Company would experience a $20,000 reduction in their fixed a $20,000 reduction in their fixed overhead costs if they started to buy the overhead costs if they started to buy the remote controls from the outside vendor.remote controls from the outside vendor.

This amount of fixed cost is now relevant This amount of fixed cost is now relevant since it is a future differential cost.since it is a future differential cost.


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Make or Buy RevisitedMake or Buy RevisitedThe EFG Company

Make BuyUnits needed 30,000 30,000

Total relevant cost:Cost to purchase ($5.50 each) 165,000$ Direct materials cost 75,000$ Direct labor cost 45,000 Variable overhead cost 30,000 Fixed overhead cost 60,000 40,000



of buying the controls


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Explain the effects of Explain the effects of fixed costs and fixed costs and

opportunity costs on opportunity costs on outsourcing outsourcing decisions.decisions.


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Opportunity CostsOpportunity Costs

An An opportunity costopportunity cost is something is something of value that is given up when one of value that is given up when one alternative is chosen over another. alternative is chosen over another.

There is usually an opportunity cost There is usually an opportunity cost involved when faced with a make or involved when faced with a make or buy decision. If we choose not to buy decision. If we choose not to make an item, those productive make an item, those productive resources can usually be put to a resources can usually be put to a profitable alternative use.profitable alternative use.


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Opportunity Cost Opportunity Cost ExampleExample

Assume that if the EFG Company Assume that if the EFG Company purchases the remote controls from the purchases the remote controls from the outside vendor, they could use the outside vendor, they could use the released production capacity to make released production capacity to make remote control boats.remote control boats.

The boats would use the same remote The boats would use the same remote control (which the vendor would control (which the vendor would supply), and should not cause a supply), and should not cause a reduction in the sales of the remote reduction in the sales of the remote control cars.control cars.© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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Let’s return to the original make or Let’s return to the original make or buy decision, where there was no buy decision, where there was no change in the fixed overhead costs.change in the fixed overhead costs.

Assume that the sales of the remote Assume that the sales of the remote control boats would result in a control boats would result in a contribution margin of $10 per boat. contribution margin of $10 per boat. Estimated sales of remote control Estimated sales of remote control boats are 5,000 units per period.boats are 5,000 units per period.


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The EFG CompanyMake Buy

Units needed 30,000 30,000

Total relevant cost:Cost to purchase ($5.50 each) 165,000$ Direct materials cost 75,000$ Direct labor cost 45,000 Variable overhead cost 30,000 Opportunity cost 50,000



of buying the controls


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Opportunity Cost Opportunity Cost AnalysisAnalysis

The $50,000 opportunity cost is added to The $50,000 opportunity cost is added to the relevant cost of the make decision.the relevant cost of the make decision.

If they make the controls, they are unable If they make the controls, they are unable to make the boats and unable to realize to make the boats and unable to realize the increased profits from the boat sales.the increased profits from the boat sales.

Without the opportunity cost, the choice Without the opportunity cost, the choice is to make the units. With the opportunity is to make the units. With the opportunity cost, the choice is to buy the units.cost, the choice is to buy the units.

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Analyze your dinner plans for Analyze your dinner plans for tonight as a make or buy decision. tonight as a make or buy decision. What are the relevant costs of What are the relevant costs of making a hamburger meal at home making a hamburger meal at home versus the cost of buying a versus the cost of buying a hamburger meal at a restaurant?hamburger meal at a restaurant?

What are some of the qualitative What are some of the qualitative factors that you would consider in factors that you would consider in this decision?this decision?© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

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The End of Chapter The End of Chapter M6M6


1 chapter m6 making decisions using relevant information © 2007 pearson custom publishing

Documents

relevant costs costs

decision alternatives

irrelevant information

management decision

economic decision

particular decision

financial decision

irrelevant costs