RELEVANT COSTS FOR DECISION MAKING

CHAPTER 111

Five-Step Decision-Making Process

Step 1:Obtain

Information

Step 5:Evaluate

Performance

Step 4:Implement

TheDecision

Step 3:Choose

AnAlternative

Step 2:Make

PredictionsAboutFutureCosts

Feedback

Requirements for accounting information

Accounting information is useful for decision Accounting information is useful for decision making if it ismaking if it isReliable,Timely,Relevant.

3

Relevant cost

A relevant cost is a cost that differs between alternatives.

1 2

      There are 3 main recognition criteria:

• Cash-flows• Future costs• Incremental costs

Mr. Kiệm’s journey

Mr. Kiệm bought a Hue - Hanoi return ticket from Vietnam airlines. He arrived at Hanoi on Monday and will return to Hue on Friday. He doesn’t know that his company’s leaders flew to Hanoi in this week and are going to fly back to Hue on Friday, too. Mr. Kiệm thought that he should help his company save some money so he required Vietnam Airlines to refund his return ticket and flew in his company’s helicopter. Is his decision correct? Is cost of the Hanoi – Hue journey by the company’s

helicopter relevant? Is cost of the Hanoi – Hue journey by Vietnam Airlines

relevant? What do the company’s shareholders want Mr. Kiệm to do?

5

Mr. Kiệm’s journey

Mr. Kiệm is a manager in his company and he is evaluated based on his division’s reporting profit. When Mr. Kiệm received his division’s monthly income statement, he discovered that he was allocated cost of the Hanoi-Hue helicopter journey twice as much as cost of Vietnam Airlines one. Mr. Kiệm asked the company’s accountants and knew that all passengers were allocated the journey’s cost. Mr. Kiệm was allocated the same cost as the Vice President who required that journey. Is Mr. Kiệm’s decision correct?

6

Identifying Relevant Costs

Annual Cost of Fixed Items

Cost per Mile

1 Annual straight-line depreciation on car 2,800$ 0.280$ 2 Cost of gasoline 0.050 3 Annual cost of auto insurance and license 1,380 0.138 4 Maintenance and repairs 0.065 5 Parking fees at school 360 0.036 6 Total average cost 0.569$

Automobile Costs (based on 10,000 miles driven per year)

Cynthia, a Boston student, is considering visiting her friend in New York. She can drive or take the train. By car it is 230 miles to her friend’s

apartment. She is trying to decide which alternative is less expensive and has gathered the following information:

Cynthia, a Boston student, is considering visiting her friend in New York. She can drive or take the train. By car it is 230 miles to her friend’s

apartment. She is trying to decide which alternative is less expensive and has gathered the following information:

$45 per month $45 per month × 8 months× 8 months$45 per month $45 per month × 8 months× 8 months $1.60 per gallon $1.60 per gallon ÷ 32 MPG÷ 32 MPG$1.60 per gallon $1.60 per gallon ÷ 32 MPG÷ 32 MPG

$18,000 cost $18,000 cost –– $4,000 salvage value $4,000 salvage value ÷ 5 years÷ 5 years$18,000 cost $18,000 cost –– $4,000 salvage value $4,000 salvage value ÷ 5 years÷ 5 years

Identifying Relevant Costs

7 Reduction in resale value of car per mile of wear 0.026$ 8 Round-tip train fare 104$ 9 Benefits of relaxing on train trip ????

10 Cost of putting dog in kennel while gone 40$ 11 Benefit of having car in New York ????12 Hassle of parking car in New York ????13 Per day cost of parking car in New York 25$

Some Additional Information

Annual Cost of Fixed Items

Cost per Mile

1 Annual straight-line depreciation on car 2,800$ 0.280$ 2 Cost of gasoline 0.050 3 Annual cost of auto insurance and license 1,380 0.138 4 Maintenance and repairs 0.065 5 Parking fees at school 360 0.036 6 Total average cost 0.569$

Automobile Costs (based on 10,000 miles driven per year)

Types of Decisions

One-Time-Only Special Orders Make or Buy Insourcing vs. Outsourcing Branch / Segment: Adding or

Discontinuing Product-Mix (Utilization of constraint

resources) Equipment Replacement

One-Time-Only Special Orders Accepting or rejecting special orders

when there is idle production capacity and the special orders has no long-run implications

Decision Rule: does the special order generate additional operating income? Yes – accept No – reject

Compares relevant revenues and relevant costs to determine profitability

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.

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?

Special Orders

Increase in revenue Increase in costs Increase in net income

Increase in revenue Increase in costs Increase in net income

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)

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)

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. $50b. $10c. $15d. $29

Quick Check

A company is evaluating an one-off contract that requires two types of material (T and V). Data relating to the material requirements are as follows:

Material Quantity needed Quantity Original cost of Current Current

type for project currently quantity in stock purchase resalein stock price price

kg kg £/kg £/kg £/kg

T 500 100 40 45 44

V 400 200 55 52 40

Material T is regularly used by the company in normal production. Material V is no longer in use by the company and has no alternative use within the business.

What is the total relevant cost of materials for the contract? A £40,400

B £40,900 C £43,400 D £43,900

Quick Check

All of a company's skilled labour, which is paid £8 per hour, is fully employed manufacturing a product to which the following data refer:

£ per unit £ per UnitSelling price 60Less Variable costs: Skilled labour 20Others 15

(35)Contribution 25The one-off contract requires 90 skilled labour hours to complete. No other

supplies of skilled labour are available.What is the total relevant skilled labour cost of the contract?

A £720B £900 C £1,620 D £2,160

The Make or Buy Decision

A decision concerning whether an item A decision concerning whether an item should be produced internally or should be produced internally or

purchased from an outside supplier is purchased from an outside supplier is called a “make or buy” decision.called a “make or buy” decision.

Let’s look at Let’s look at Rạng Đông Company example. Company example.

A decision concerning whether an item A decision concerning whether an item should be produced internally or should be produced internally or

purchased from an outside supplier is purchased from an outside supplier is called a “make or buy” decision.called a “make or buy” decision.

Let’s look at Let’s look at Rạng Đông Company example. Company example.

The Make or Buy Decision

Rạng Đông manufactures thermos-flask. Department A manufactures silvered inner containers.

The unit product cost of this part is:

Direct materials $ 9 Direct labor 5 Variable overhead 1 Depreciation of special equip. 3 Supervisor's salary 2 General factory overhead 10 Unit product cost 30$

Direct materials $ 9 Direct labor 5 Variable overhead 1 Depreciation of special equip. 3 Supervisor's salary 2 General factory overhead 10 Unit product cost 30$

The Make or Buy Decision

The special equipment used to manufacture inner containers 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 unit product cost is based on 20,000 units produced each year.

A Chinese supplier has offered to provide the 20,000 units at a cost of $25 per unit. Should we accept the supplier’s offer?Should we accept the supplier’s offer?

The special equipment used to manufacture inner containers 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 unit product cost is based on 20,000 units produced each year.

A Chinese supplier has offered to provide the 20,000 units at a cost of $25 per unit. Should we accept the supplier’s offer?Should we accept the supplier’s offer?

The Make or Buy Decision

Should we make or buy inner containers?Should we make or buy inner containers?

Cost Per Unit Cost of 20,000 Units

Make BuyOutside purchase price $ 25 $ 500,000

Direct materials 9$ Direct labor 5 Variable overhead 1 Depreciation of equip. 3 Supervisor's salary 2 General factory overhead 10 Total cost 30$ -$ 500,000$

The Make or Buy Decision

DECISION RULEIn deciding whether to accept the outside

supplier’s offer, Rạng Đông isolated the relevant costs of making the part by

eliminatingeliminating: The sunk costs. The future costs that will not differ between

making or buying the parts.

DECISION RULEIn deciding whether to accept the outside

supplier’s offer, Rạng Đông isolated the relevant costs of making the part by

eliminatingeliminating: The sunk costs. The future costs that will not differ between

making or buying the parts.

Adding/Dropping Segments

One of the most important decisions One of the most important decisions managers make is whether to add or managers make is whether to add or drop a business segment such as a drop a business segment such as a

product or a store.product or a store.

Let’s see how relevant costs Let’s see how relevant costs should be used in this should be used in this

decision.decision.

One of the most important decisions One of the most important decisions managers make is whether to add or managers make is whether to add or drop a business segment such as a drop a business segment such as a

product or a store.product or a store.

Let’s see how relevant costs Let’s see how relevant costs should be used in this should be used in this

decision.decision.

Adding/Dropping Segments

Due to the declining popularity of digital Due to the declining popularity of digital watches, Lovell Company’s digital watches, Lovell Company’s digital

watch line has not reported a profit for watch line has not reported a profit for several years. An income statement several years. An income statement

for last year is shown on the next for last year is shown on the next screen.screen.

Due to the declining popularity of digital Due to the declining popularity of digital watches, Lovell Company’s digital watches, Lovell Company’s digital

watch line has not reported a profit for watch line has not reported a profit for several years. An income statement several years. An income statement

for last year is shown on the next for last year is shown on the next screen.screen.

Adding/Dropping SegmentsSegment Income Statement

Digital WatchesSales 500,000$ Less: variable expenses Variable manufacturing costs 120,000$ Variable shipping costs 5,000 Commissions 75,000 200,000 Contribution margin 300,000$ Less: fixed expenses General factory overhead 60,000$ Salary of line manager 90,000 Depreciation of equipment 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 400,000 Net operating loss (100,000)$

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.

• The equipment used to manufacture digital watches has no resale value or alternative use.

Should Lovell retain or dropthe digital watch segment?

• 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.

• The equipment used to manufacture digital watches has no resale value or alternative use.

Should Lovell retain or dropthe digital watch segment?

A Contribution Margin Approach

DECISION RULELovell 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 RULELovell 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.

A Contribution Margin Approach

Contribution MarginSolution

Contribution margin lost if digital   watches are dropped

Less fixed costs that can be avoided

- Net disadvantage -$

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 Let’s look at this second approach.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 Let’s look at this second approach.approach.

Comparative Income ApproachSolution

Keep Digital

Watches

Drop Digital

Watches Difference Sales 500,000$ -$ 500,000$ Less variable expenses: - Manufacturing expenses 120,000 - 120,000 Shipping 5,000 - 5,000 Commissions 75,000 - 75,000 Total variable expenses 200,000 - 200,000 Contribution margin 300,000 - 300,000 Less fixed expenses: General factory overhead 60,000 Salary of line manager 90,000 Depreciation 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 Total fixed expenses 400,000 Net operating loss (100,000)$

Utilization of a Constrained Resource

Firms often face the problem of deciding Firms often face the problem of deciding how to best utilize a constrained resource.how to best utilize a constrained resource.

Usually fixed costs are not affected by this Usually fixed costs are not affected by this particular decision, so management can particular decision, so management can focus on maximizing total contribution focus on maximizing total contribution margin.margin.

Let’s look at the Ensign Company example.Let’s look at the Ensign Company example.

Firms often face the problem of deciding Firms often face the problem of deciding how to best utilize a constrained resource.how to best utilize a constrained resource.

Usually fixed costs are not affected by this Usually fixed costs are not affected by this particular decision, so management can particular decision, so management can focus on maximizing total contribution focus on maximizing total contribution margin.margin.

Let’s look at the Ensign Company example.Let’s look at the Ensign Company example.

Utilization of a Constrained ResourceEnsign Company produces two products

and selected data is shown below:

Utilization of a Constrained Resource

Machine A1 is the constrained resource Machine A1 is the constrained resource and is being used at 100% of its and is being used at 100% of its capacity. capacity.

There is excess capacity on all other There is excess capacity on all other machines. machines.

Machine A1 has a capacity of 2,400 Machine A1 has a capacity of 2,400 minutes per week.minutes per week.

Should Ensign focus its efforts on Should Ensign focus its efforts on Product 1 or 2?Product 1 or 2?

Machine A1 is the constrained resource Machine A1 is the constrained resource and is being used at 100% of its and is being used at 100% of its capacity. capacity.

There is excess capacity on all other There is excess capacity on all other machines. machines.

Machine A1 has a capacity of 2,400 Machine A1 has a capacity of 2,400 minutes per week.minutes per week.

Should Ensign focus its efforts on Should Ensign focus its efforts on Product 1 or 2?Product 1 or 2?

Quick Check

How many units of each product can be processed through Machine A1 in one minute?

Product 1 Product 2a. 1 unit 0.5 unitb. 1 unit 2.0 unitsc. 2 units 1.0 unitd. 2 units 0.5 unit

How many units of each product can be processed through Machine A1 in one minute?

Product 1 Product 2a. 1 unit 0.5 unitb. 1 unit 2.0 unitsc. 2 units 1.0 unitd. 2 units 0.5 unit

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 1b. Product 2c. They both would generate the same profitd. Cannot be determined

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 1b. Product 2c. They both would generate the same profitd. Cannot be determined

Utilization of a Constrained Resource

The key is the contribution margin per unit of the constrained resource.

Utilization of a Constrained Resource

Let’s see how this plan would work.Alloting Our Constrained Recource (Machine A1)

Weekly demand for Product 2 unitsTime required per unit × min.Total time required to make Product 2 min.

Total time available min.Time used to make Product 2 min.Time available for Product 1 min.Time required per unit ÷ min.Production of Product 1 units

Alloting Our Constrained Recource (Machine A1)

Weekly demand for Product 2 unitsTime required per unit × min.Total time required to make Product 2 min.

Total time available min.Time used to make Product 2 min.Time available for Product 1 min.Time required per unit ÷ min.Production of Product 1 units

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.

Product 1 Product 2Production and sales (units) 1,300 2,200 Contribution margin per unit 24$ 15$ Total contribution margin 31,200$ 33,000$

The total contribution margin for Ensign is $64,200.The total contribution margin for Ensign is $64,200.The total contribution margin for Ensign is $64,200.The total contribution margin for Ensign is $64,200.

Linear programming – multiple constrained resourcesLinear programming is a technique for solving

problems of profit maximisation or cost minimisation and resource allocation.

   Usefull in the cases of multiple constrained resources

Steps:1. Define variables

2. Establish constraints

3. Construction objective function

4. Graph the constraints

5. Establish feasible region

6. Add iso-profit/contribution line

7. Determine optimal solution

Utilization of a Constrained Resource

Units of product 1 = X; Units of product 1 = Y X + 0,5Y <(=)2400 Contribution = 24X +15Y

X< (=)2000; Y<(=)2200 X>=0; Y>=0

Units of product 1 = X; Units of product 1 = Y X + 0,5Y <(=)2400 Contribution = 24X +15Y

X< (=)2000; Y<(=)2200 X>=0; Y>=0

39

Utilization of a Constrained Resource

X

Y4800

2400

X <(=)2000

Y<(=)2200

2200

2000

X + 0,5Y<(=)2400

Area of feasible solutions24X+15Y

40

Quick Check

Colonial Heritage makes reproduction Colonial Heritage makes reproduction colonial furniture from select hardwoods.colonial furniture from select hardwoods.

The company’s supplier of hardwood will The company’s supplier of hardwood will only be able to supply 2,000 board feet only be able to supply 2,000 board feet this month. Is this enough hardwood to this month. Is this enough hardwood to satisfy demand?satisfy demand?a. Yesa. Yes

b. Nob. No

Chairs Tables Selling price per unit $80 $400 Variable cost per unit $30 $200 Board feet per unit 2 10 Monthly demand 600 100

Quick Check

The company’s supplier of hardwood will only The company’s supplier of hardwood will only be able to supply 2,000 board feet this be able to supply 2,000 board feet this month. What plan would maximize profits?month. What plan would maximize profits?

a. 500 chairs and 100 tablesa. 500 chairs and 100 tables

b. 600 chairs and 80 tablesb. 600 chairs and 80 tables

c. 500 chairs and 80 tablesc. 500 chairs and 80 tables

d. 600 chairs and 100 tablesd. 600 chairs and 100 tables

Chairs Tables Selling price per unit $80 $400 Variable cost per unit $30 $200 Board feet per unit 2 10 Monthly demand 600 100

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 footb. $25 per board footc. $20 per board footd. Zero

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 footb. $25 per board footc. $20 per board footd. Zero

Managing Constraints

Finding ways to process more units through a resource

bottleneck

At the bottleneck itself: •Improve the process • Add overtime or another shift • Hire new workers or acquire more machines • Subcontract production

It will always profitable to continue processing a joint product after the

split-off point so long as the incremental revenue exceeds the

incremental processing costs incurred after the split-off point.

Let’s look at the Sawmill, Inc. example.

Sell or Process Further

Sell or Process Further

Sawmill, Inc. cuts logs from which unfinished lumber and sawdust are the immediate joint products.

Unfinished lumber is sold “as is” or processed further into finished lumber.

Sawdust can also be sold “as is” to gardening wholesalers or processed further into “presto-logs.”

Sawmill, Inc. cuts logs from which unfinished lumber and sawdust are the immediate joint products.

Unfinished lumber is sold “as is” or processed further into finished lumber.

Sawdust can also be sold “as is” to gardening wholesalers or processed further into “presto-logs.”

Sell or Process Further

Data about Sawmill’s joint products includes:

Per Log Lumber Sawdust

Sales value at the split-off point 140$ 40$

Sales value after further processing 270 50 Allocated joint product costs 88 12 Cost of further processing 50 20

Sell or Process Further

Analysis of Sell or Process Further

Per Log

Lumber Sawdust

Sales value after further processingSales value at the split-off pointIncremental revenueCost of further processingProfit (loss) from further processing

Equipment-Replacement Decisions Sometimes difficult due to amount of

information at hand that is irrelevant: Cost, Accumulated Depreciation and Book

Value of existing equipment Any potential Gain or Loss on the

transaction – a Financial Accounting phenomenon only

Decision Rule: Select the alternative that will generate the highest operating income

50

Equipment-Replacement Decisions In 2013 Honda Vietnam bought an Asimo robot system

used in Assembly department. The acquisition cost is VND 2.1 billions. The estimated useful life is 6 years.

In 2014 there is a new version of Asimo robots which is much more efficient than the old one. The company can save 70% of annual operating costs if it uses the new version.

The purchase price of the new version is VND 4 billions. The estimated useful life is 5 years.

If the company buy the new vesion, the current robot system can be disposed at the value of VND 1 bil.

The current annual operating cost is VND 900 millions. Should Honda Vietnam buy the new version?

End of Chapter 11