CHAPTER 6CHAPTER 6

PowerPoint Author:LuAnn Bean, Ph.D., CPA, CIA, CFE

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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Relevant InformationRelevant Information

Two primary characteristics distinguish relevant from useless information:

1. Relevant information differs among the alternatives under consideration.

2. Relevant information is future oriented.

Two primary characteristics distinguish relevant from useless information:

1. Relevant information differs among the alternatives under consideration.

2. Relevant information is future oriented.

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Sunk CostSunk CostA sunk cost has been incurred in a past transaction and cannot be changed. It is

not relevant for making current decisions.

I wish I hadn’t bought I wish I hadn’t bought that stock. Cost me that stock. Cost me

$25,000, and now it’s $25,000, and now it’s worth only $15,000. I worth only $15,000. I really need a car but really need a car but don’t have the cash!don’t have the cash!

I wish I hadn’t bought I wish I hadn’t bought that stock. Cost me that stock. Cost me

$25,000, and now it’s $25,000, and now it’s worth only $15,000. I worth only $15,000. I really need a car but really need a car but don’t have the cash!don’t have the cash!

Just sell the stock Just sell the stock and buy the car!and buy the car!

Just sell the stock Just sell the stock and buy the car!and buy the car!

You’ve already You’ve already taken the loss. The taken the loss. The $25,000 is a sunk $25,000 is a sunk

cost. Like I said, sell cost. Like I said, sell the stock and buy the stock and buy the car you need.the car you need.

You’ve already You’ve already taken the loss. The taken the loss. The $25,000 is a sunk $25,000 is a sunk

cost. Like I said, sell cost. Like I said, sell the stock and buy the stock and buy the car you need.the car you need.

I don’t want to I don’t want to take the loss!take the loss!

I don’t want to I don’t want to take the loss!take the loss!

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Opportunity CostsOpportunity CostsAn opportunity cost is the sacrifice that is incurred in order to obtain an alternative

opportunity.

I think I am beginning to see what you mean.

I think I am beginning to see what you mean.

The opportunity cost of owning the stock is $15,000.

That is the amount you could receive if you decide to sell.

The opportunity cost of owning the stock is $15,000.

That is the amount you could receive if you decide to sell.

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A quantitative focus considers

the cost, increase in profits, or other numerical aspects of the

decision.

Quantitative Versus Qualitative Quantitative Versus Qualitative CharacteristicsCharacteristics

Relevant information can have both quantitative and qualitative characteristics.

A qualitative focus considers

non-quantitative aspects such as the impact on people and

attractiveness of the products.

For example, suppose you are deciding which of two laptops to purchase. Computer A costs $300 more than Computer B. Both computers satisfy your technical requirements; however

Computer A has a more attractive appearance

Computer A Computer B

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Differential Revenue Differential Revenue and Avoidable Costand Avoidable Cost

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.

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Relevant (Avoidable) Relevant (Avoidable) CostsCosts

Unit-levelCosts

Batch-levelCosts

Product-levelCosts

Facility-levelCosts

Avoided by eliminating oneunit of product.

Avoided when a batch ofAvoided when a batch ofwork is eliminated.work is eliminated.

Avoided if a product lineis eliminated.

Some costs may be avoidedif a business segment is

eliminated.

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Segment Elimination Segment Elimination DecisionsDecisions

A three step decision:A three step decision:

1.1. Determine the amount of relevant revenue Determine the amount of relevant revenue that pertains to eliminating the segment.that pertains to eliminating the segment.

2.2. Determine the amount of cost that can be Determine the amount of cost that can be avoided if the segment is eliminated.avoided if the segment is eliminated.

3.3. If the relevant revenue is less than the If the relevant revenue is less than the avoidable cost, eliminate the segment. If not, avoidable cost, eliminate the segment. If not, continue to operate it.continue to operate it.

A three step decision:A three step decision:

1.1. Determine the amount of relevant revenue Determine the amount of relevant revenue that pertains to eliminating the segment.that pertains to eliminating the segment.

2.2. Determine the amount of cost that can be Determine the amount of cost that can be avoided if the segment is eliminated.avoided if the segment is eliminated.

3.3. If the relevant revenue is less than the If the relevant revenue is less than the avoidable cost, eliminate the segment. If not, avoidable cost, eliminate the segment. If not, continue to operate it.continue to operate it.

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Segment Elimination Segment Elimination DecisionsDecisions

Step 1:Step 1:If Premier eliminates the copier segment, it If Premier eliminates the copier segment, it will lose the $550,000 of revenue currently will lose the $550,000 of revenue currently earned. If the segment continues, the revenue earned. If the segment continues, the revenue will be earned. Since the revenue differs will be earned. Since the revenue differs between the alternatives, between the alternatives, it is relevantit is relevant..

Step 1:Step 1:If Premier eliminates the copier segment, it If Premier eliminates the copier segment, it will lose the $550,000 of revenue currently will lose the $550,000 of revenue currently earned. If the segment continues, the revenue earned. If the segment continues, the revenue will be earned. Since the revenue differs will be earned. Since the revenue differs between the alternatives, between the alternatives, it is relevantit is relevant..

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Segment Elimination Segment Elimination DecisionsDecisions

Step 2:Step 2:If Premier eliminates copiers, it will avoid the following If Premier eliminates copiers, it will avoid the following costs:costs:

Step 2:Step 2:If Premier eliminates copiers, it will avoid the following If Premier eliminates copiers, it will avoid the following costs:costs:

Unit-level costs Materials costs (120,000)$ Labor costs (160,000) Overhead (30,800) Batch-level costs Assembly setup (15,000) Materials handling (6,000) Product-level costs Engineering costs (10,000) Production manager salary (52,000) Facility-level costs Segment level Division manager salary (82,000) Administrative costs (12,200) Total relevant costs (488,000)$

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Segment Elimination Segment Elimination DecisionsDecisions

Step 3:Step 3:If Premier eliminates copiers, its profits will If Premier eliminates copiers, its profits will decrease:decrease:

Step 3:Step 3:If Premier eliminates copiers, its profits will If Premier eliminates copiers, its profits will decrease:decrease:

Revenue lost (550,000)$ Costs avoided 488,000 Decrease in profit (62,000)$

The corporate-level facility-sustaining costs will not be eliminated, but will be allocated to the

remaining segments.

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Qualitative Qualitative ConsiderationsConsiderations

1.1. Employee lives will be disrupted.Employee lives will be disrupted.

2.2. Sales of different product lines are frequently Sales of different product lines are frequently interdependent.interdependent.

3.3. What will happen to the space freed by the What will happen to the space freed by the eliminated segment?eliminated segment?

4.4. Volume changes can affect elimination Volume changes can affect elimination decisions.decisions.

1.1. Employee lives will be disrupted.Employee lives will be disrupted.

2.2. Sales of different product lines are frequently Sales of different product lines are frequently interdependent.interdependent.

3.3. What will happen to the space freed by the What will happen to the space freed by the eliminated segment?eliminated segment?

4.4. Volume changes can affect elimination Volume changes can affect elimination decisions.decisions.

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Relationships Between Relationships Between Avoidable Costs and Avoidable Costs and Business ActivityBusiness Activity

1. Special order decisions affect unit-level and possibly batch-level costs.

2. Outsourcing can avoid many product-level as well as unit- and batch-level costs.

3. Segment elimination can avoid some of the facility-level costs.

1. Special order decisions affect unit-level and possibly batch-level costs.

2. Outsourcing can avoid many product-level as well as unit- and batch-level costs.

3. Segment elimination can avoid some of the facility-level costs.

The more complex the decision level, the more opportunities there are to avoid costs.

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Equipment Replacement Equipment Replacement DecisionsDecisions

The equipment replacement decision should be based on profitability rather than physical deterioration. Consider

the following:

Original cost 90,000$ Accumulated depreciation (33,000) Book value 57,000$

Market value (now) 14,000$ Salvage value (in 5 years) 2,000 Annual depreciation expenses 11,000 Operating expenses ($9,000 × 5 years) 45,000

Cost 29,000$ Salvage value (in 5 years) 4,000 Operating expenses ($4,500 × 5 years) 22,500

Old Machine

New Machine

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Equipment Equipment Replacement Decisions Replacement Decisions – – Quantitative AnalysisQuantitative Analysis

1.1. The original cost, current book value, accumulated The original cost, current book value, accumulated depreciation, and annual depreciation expense are depreciation, and annual depreciation expense are measures of cost of the old machine relating to prior measures of cost of the old machine relating to prior periods. They are irrelevant because they are sunk costs.periods. They are irrelevant because they are sunk costs.

2.2. The $14,000 market value of the old machine is an The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement opportunity cost and is relevant to the replacement decision.decision.

3.3. The salvage value of the old machine reduces the The salvage value of the old machine reduces the opportunity cost. The opportunity cost of using the old opportunity cost. The opportunity cost of using the old machine for five more years is $12,000 ($14,000 machine for five more years is $12,000 ($14,000 – – $2,000).$2,000).

4.4. The $45,000 operating expenses of using the old machine The $45,000 operating expenses of using the old machine can be avoided if it is replaced. It is a relevant cost.can be avoided if it is replaced. It is a relevant cost.

1.1. The original cost, current book value, accumulated The original cost, current book value, accumulated depreciation, and annual depreciation expense are depreciation, and annual depreciation expense are measures of cost of the old machine relating to prior measures of cost of the old machine relating to prior periods. They are irrelevant because they are sunk costs.periods. They are irrelevant because they are sunk costs.

2.2. The $14,000 market value of the old machine is an The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement opportunity cost and is relevant to the replacement decision.decision.

3.3. The salvage value of the old machine reduces the The salvage value of the old machine reduces the opportunity cost. The opportunity cost of using the old opportunity cost. The opportunity cost of using the old machine for five more years is $12,000 ($14,000 machine for five more years is $12,000 ($14,000 – – $2,000).$2,000).

4.4. The $45,000 operating expenses of using the old machine The $45,000 operating expenses of using the old machine can be avoided if it is replaced. It is a relevant cost.can be avoided if it is replaced. It is a relevant cost.

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What are the relevant costs if What are the relevant costs if Premier purchases and uses the Premier purchases and uses the new machine?new machine?

1.1. The cost of the new machine can be avoided by The cost of the new machine can be avoided by keeping the old machine. It is a relevant cost.keeping the old machine. It is a relevant cost.

2.2. The relevant cost of purchasing the new machine The relevant cost of purchasing the new machine is $25,000 ($29,000 is $25,000 ($29,000 – $4,000)– $4,000)..

3.3. The $22,500 of operating expenses can be The $22,500 of operating expenses can be avoided by keeping the old machine. The avoided by keeping the old machine. The operating expenses are relevant costs.operating expenses are relevant costs.

Let’s summarize the relevant costs for the two machines.Let’s summarize the relevant costs for the two machines.

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Equipment Equipment Replacement DecisionsReplacement Decisions

Opportunity cost 14,000$ Salvage value (2,000) Operating expenses 45,000 Total 57,000$

Cost 29,000$ Salvage value (4,000) Operating expenses 22,500 Total 47,500$

Old Machine

New Machine

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).

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A decision maker under significant pressure to report higher profitability may be willing to sacrifice tomorrow’s profits to look better today. Here is an example:

While the total cost at the end of the five-year period is $9,500 lessif the equipment is replaced ($100,000 - $90,500), the total costs atthe end of the first year are higher by $32,500 ($52,500 - $20,000) if the old machine is replaced.

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Theory of Constraints

Many businesses use a management practice known as the theory of constraints (TOC) to increase profitability by managing bottlenecks or constrained resources.

TOC’s primary objective is to identify the bottlenecks restricting the operations of the business and then to open those bottlenecks through a practice known as relaxing the constraints.

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End of Chapter 6End of Chapter 6