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Chapter 5: Relevant Information & Decision Making

Decision-making is a fundamental part of management. Managers are constantly faced


with problems of deciding what product to sell, what production method to use,
whether to make or buy component parts, what prices to charge, what channels of
distribution to use, whether to accept special orders at special prices, and so forth. This
chapter covers the role of management accounting information in a variety of
marketing and production decisions.

5.1The Concept of Relevance


Accountants have an important role in the decision-making process, not as a decision
maker but as collectors and reporters of relevant information. What makes information
relevant to a decision problem? Relevant information is the predicted future costs and
revenues that will differ among the alternatives. These two criteria are discussed here
under:
Bearing on the Future: To be relevant to a decision, cost or benefit information must
involve a future event. Relevant information is a prediction of the future, not a
summary of the past. Historical (past) data have no bearing on a decision. Such data
can have an indirect bearing on a decision because they may help in predicting the
future. But past figures, in themselves, are irrelevant to the decision itself. Why?
Because decision-making affect future, but not past. Nothing can alter what has already
happened.
Different under Competing Alternatives: Relevant information must involve future
costs or benefits that differ among the alternatives. Costs or benefits that are the same
across all the available alternatives have no bearing on the decision. For example, if
management is evaluating the purchase of either a manual or an automated drill press,
both of which require skilled labor costing Br. 10 per hour, the labor rate is not relevant
because it is the same for both alternatives.

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Why Isolate Relevant Information?
Why is it important for the management accountant to isolate the relevant costs and
benefits in a decision analysis? The reasons are twofold.
First, generating information is a costly process. The management accountant can
simplify and shorten the data gathering process by focusing on only relevant
information.
Second, people can effectively use only a limited amount of information. If a manager is
provided with irrelevant revenues and costs, these figures can cause information
overload, and decision-making effectiveness of the manager declines.
Example (1) Marina Company, a manufacturer of a line of ashtrays, is thinking of using
aluminum instead of copper in the manufacture of its product. Historical direct
material costs were Br. 0.30 per unit. The company expected future costs for aluminum
is Br 0.20 and it is unchanged for copper. Direct labor cost was Br. 0.70 per unit and will
not be affected by the switch in materials. The analysis in a nutshell is as follows.
Copper Aluminum Difference
Direct material Br. 0.30 Br. 0.20 Br. 0.10
Direct labor 0.70 0.70 -
Required: Given the above-summarized data identify the relevant data for the decision
on hand.

5.2 Alternative Choice Decisions


Many of the decisions described in this chapter are frequently referred to as alternative
choice decision. Alternative choice decisions are situations with two or more courses of
action from which the decision maker must select the best alternative.
The variety of alternative choice decisions is limitless. Some business example follows:
 Should we accept a special order for a product below our normal selling price?
 Should we raise the price of a product or maintain the current price?
 Should we make or buy a component part?
 Should we sell a joint product at the split off point or process it further?
 Should we keep our copying machine or acquire a faster one?

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The analyses of these and other types of alternative choice decisions are aided by
relevant cost and benefit data.

5.2.1 Marketing Decisions


The discussions that follow illustrate a variety marketing and production decisions.
The marketing decisions for which we examine relevant information include special
order decisions, addition or deletion, and optimal use of limited resources.

Special Order Decisions


A special order is a one-time order that is not considered part of the company’s normal
on going business. For example, a discount department store chain planning a big
spring sale offers to make a large one-time purchase of a firm’s product but wants a
reduced price. In general, a special order is profitable as long as the incremental
revenue from the special order exceeds the incremental costs of the order. The
incremental revenue in this decision will be the price per unit offered by the potential
customer times the number of units to be purchased. The incremental costs will be the
amount of the expected cost increase if the offer is accepted. The incremental cost
usually includes variable manufacturing costs of producing the units. Since the units
being sold in the special order are not being sold through the firm normal distribution
channel, the firm may or may not incur variable selling and administrative expenses in
conjunction with the special order.
The incremental costs usually do not include fixed manufacturing costs. Although the
fixed costs must be incurred to permit production, the amount of fixed costs incurred
by the firm usually will not increase if the special order offer is accepted. For the same
reason, other fixed expenses, such as fixed selling and administrative expenses, are
usually not relevant in the special order price.
However, management must also be assured that it has sufficient capacity to produce
the special order without affecting normal sales. When there is no excess capacity, the
opportunity cost of using the firm’s facilities for the special order are also relevant to the
decision. The opportunity cost would be the contribution margin forgone on regular

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sales that have to be reduced to accommodate the special order. The relevant costs to
accept the special order, therefore, would include a forgone contribution margin on
regular sales that could not be made in addition to the incremental costs associated with
the special order that have already been discussed.
Example-1: Consider the following details of the income statement of Samson Company
for the year just ended December 31, 20 x 3.
Sales (1,000,000 units) Br. 20,000,000
Manufacturing cost of goods sold 15,000,000
Gross margin Br. 5,000,000
Selling and administrative expenses 4,000,000
Operating income Br. 1,000,000

Samson’s fixed manufacturing costs were Br. 3 million and its fixed selling and
administrative costs were Br. 2.9 million.
Near the end of the year, Ethio Company offered Samson Br. 13 per unit for 100,000 unit
special order. The special order would not affect Samson’s regular business in any way.
Furthermore, the special sales order would not affect total fixed costs and would not
require any additional variable selling and administrative expenses.
Instruction: Should Samson accept or reject the special order? By what percentage the
operating income decreases or increases if the order had been accepted? Assume that
the company would utilize its idle manufacturing capacity to accept the special order.
Example-2: Lucy Company has the capacity to produce 15,000 units per month. Current
regular production and sales are 10,000 units per month at a selling price of Br. 15 each.
Based on the current production level, the following costs are to be incurred per unit:
Direct materials Br. 5.00
Direct labor 3.00
Variable factory overhead (FOH) 0.75
Fixed FOH 1.50

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Variable selling expense 0.25
Fixed administrative expense 1.00
Lucy Company has received special order from a customer that wants to purchase 4,000
units at Br. 10 each. There would be no selling expense in connection with this special
order.

Instructions:
a. Should Lucy Company accepts or rejects the special order? Why or Why not?
Assume that the special order should not disturb regular business.
b. Suppose that the special order was for 8,000 units instead of 4,000 units. Thus,
regular business would be reduced by 3,000 units to accept the special order because
production capacity cannot be expanded in the short run. What would be the
overall profit of the firm if it accepts this order?
c. Refer the data given in requirement (b) above. At what selling price per unit from
the customer would the Lucy Company be economically indifferent between
accepting and rejecting the offer?
Example-3: ABC Company makes and sells 10,000 units of a certain product. The total
manufacturing cost of goods made is Br400, 000. Suppose XYZ Company offered Br38
per unit for 1,000 units special order that:
 Would not affect the regular business in any way
 Would not affect fixed costs
 Would not require any additional variable selling and administrative expenses
 Would use some other wise idle manufacturing capacity
Required
Should ABC Company accept the special order?
The income statement of the company for the most recent period is given below:
Sales-------------------------------------------------------------500,000
Variable costs
Manufacturing----------------------------360,000
Selling and admin-------------------------30,000-----------390,000
Contribution margin-----------------------------------------110,000
Fixed costs
Manufacturing------------------------------40,000
Selling and admin--------------------------50,000-----------90,000
Operating income----------------------------------------------20,000

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Deletion or Addition of Products or Departments
Decisions relating to whether old product lines or other segments of a company should
be dropped and new ones added are among the most difficult that managers have to
make. In such decisions, many factors must be considered that are both qualitative and
quantitative in nature. Ultimately, however, any final decision to drop an old segment
or to add a new one is going to hinge primarily on the impact the decision will have on
net operating income. To assess this impact, it is necessary to make a careful analysis of
the costs involved. To this end, let us try to distinguish the difference between
avoidable and unavoidable fixed expenses.
Fixed costs are divided into two categories, avoidable and unavoidable.
Avoidablecosts are costs that will not continue if an ongoing operation is changed,
deleted or eliminated. These costs are relevant costs in decision-making. Examples of
avoidable costs include departmental salaries and other costs that could be avoided by
not operating the specific department. Unavoidable costs are costs that continue even
if a subunit or an activity is eliminated and are not relevant for decision. The reason for
this is that such costs are not affected by a decision to delete a particular activity.
Unavoidable costs include many common costs, which are defined as those costs of
facilities and services that are shared by users. Examples are store depreciation,
heating, air conditioning, and general management expenses.
Example-1: Eyoha Department Store has three major departments: groceries, general
merchandise, and drugs. Management is considering dropping groceries, which have
consistently shown a net loss. The following table reports the present annual net
income (in thousands).

DEPARTMENTS
Groceries General merchandise Drugs Total
Sales Br. 1,000 Br. 800 Br. 100 1,900
Variable COGS* & Expenses 800 560 60 1,420
Contribution margin Br. 200 Br. 240 Br. 40 Br. 480
Fixed expenses

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Avoidable Br. 150 Br. 100 Br. 15 Br. 265
Unavoidable 60 100 20 180
Trial fixed expenses Br. 210 Br. 200 Br. 35 Br. 445
Operating income (loss) Br. (10) Br. 40 Br. 5 Br. 35
*COGS denote cost of goods sold.
Instructions:
a. Which alternative would you recommend if the only alternatives to be
considered are dropping or continuing the grocery department? Assume that
the total assets would be unaffected by the decision and the space made available
by dropping groceries would remain idle.
b. Refer the income statement presented above. However, assume that the space
made available by dropping groceries could be used to expand the general
merchandise department. The space would be occupied by merchandise that
would increase sales by Br. 500,000, generate a 30% contribution margin
percentage and have additional avoidable fixed costs of Br. 70,000. Should
Eyoha discontinue grocery and expand merchandise department?

Optimal Use of Limited Resources


Managers are routinely faced with the problem of deciding how scarce resources are
going to be utilized. A scarce resource or a limiting factor refers to any factor that
restrict or constraint the production or sale of a product or service. It include the
following, among others, labor hours, machine hours, square feet of floor space, cubic
meters of display space .A department store, for example, has a limited amount of floor
space and therefore cannot stock every product that may be available. A manufacturing
firm has a limited number of machine- hours and a limited number of direct labor-
hours at its disposal. When capacity becomes pressed because of scarce resource, the
firm is said to have a constraint.
When a plant that makes more than one product is operating at capacity, managers
often must decide which orders to accept. The contribution margin technique also
applies here, because the product to be emphasized or the order to be accepted is the

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one that makes the biggest total profit contribution per unit of the limiting factor. Fixed
cost are usually unaffected by such choices.
In such kind of decision, the contribution margin technique must be used wisely.
Managers sometimes mistakenly favor those products with the biggest contribution
margin or gross margin per sales birr, without regard to scarce resources.
Example (1):Wajo Company has two products: a plain cellular phone and a fancier
cellular phone with many special features. Unit data follow:
Plain Phone Fancy Phone
Selling price Br.80 Br.120
Variable costs 64 84
Contribution margin Br.16 Br.36
Contribution margin ratio 20% 30%

Instructions:
a. Which product is more profitable? On which should the firm spend its
resources? Assume that sales are restricted by demand for only a limited number
of phones.
b. Now suppose that annual demand for phones of both types is more than the
company can produce in the next year and the major constraint is the availability
of time on a processing machine. Plain Phone requires one hour of processing on
the machine, Fancy Phone requires three hours of processing. Which product is
more profitable? Assume that only 10, 000 machine hours of capacity are
available.

5.2.2 Production Decisions


This part and the preceding one illustrate relevant costs for many types of decisions.
Does this mean that each decision requires a different approach to identifying relevant
costs? No. The fundamental principle in all decision situations is that relevant costs are
future costs that differ among alternatives. The principle is simple, but its application is
not always straightforward.

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Managers must have tools at their disposal to assist them in distinguishing relevant and
irrelevant costs so that the latter can be eliminated from the decisions framework.
What costs are relevant in decision-making? The answer is easy. Any future cost that
makes a difference between decisions alternative is relevant for decision purpose. All
costs are considered relevant, except
a) Sunk costs. A sunk cost is a cost that has already been incurred and that cannot
be avoided regardless of which course of action a manager may decide to take. As
such, sunk costs have no relevance to future events and must be ignored in
decision-making.
b) Future costs that do not differ between the alternatives at hand.
Relevant costs are avoidable costs. An avoidable cost can be defined as cost that can be
eliminated as a result of choosing one alternative over another in a decision-making
situation.
In management accounting, the term avoidable is synonymous with differential cost.
These terms are frequently used interchangeably. To identify the costs that are
avoidable (differential) in a particular decision situation, the manager’s approach to cost
analysis should include the following steps:
 Assemble all of the costs associated with each alternative being considered.
 Eliminate those costs that are sunk.
 Eliminate those that do not differ between alternatives.
 Make a decision based on the remaining costs. These costs will be the differential
or avoidable costs, and hence the costs relevant to the decision to be made.

Make or Buy Decisions


Managers in manufacturing companies are often faced with the problem whether to
manufacture a component used in manufacturing a product or to purchase from the
outside. Production of such basic materials as screws, nails, washers, sheet metal and so
on is not usually economical owing to specialization and returns to scale. These
materials can almost always be acquired more cheaply from outside suppliers. But for

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many materials, such as subassemblies and special parts, it is not always clear which is
least costly means of acquisition. The cost and management accounting system assist
managers in arriving at a correct decision by presenting suitable analysis of the cost of
production and comparing it with the purchase price of the product.
In make or buy decisions, the appropriate means of analysis is to compare the relevant
cost of buying the part with the relevant cots of making the part. Here relevant cost of
buying the component is typically the amount paid to supplier. It may also include
transportation costs incurred to get the component to the company’s plant and costs
incurred to process the part upon receipt.
The relevant cost of making the component is often the variable costs incurred to
produce the component. In some cases, however, the company will need to acquire
special equipment to produce the product or will hire additional supervisory personnel
to assist with making the product. These incremental fixed costs will be part of the
relevant cost of making the part. The alternative chosen make or buy, is typically the
one with the lowest cost.

In the final decision regarding make or buy qualitative factors, besides the quantitative
data, should be considered as part of the decision.

In make or buy decision, the following qualitative factors, besides the quantitative
considerations may favor the decision to “buy”:
 Advantage of long-term relationship with suppliers.
 Possibility of shortage of material or labor for making the component.
 Uninterrupted supply of requisite quality from reliable suppliers.
 The internal demand for the product under consideration is small and, as such, it
is no use to set up manufacturing facilities for it and so forth.
On the contrary, the following qualitative factors may favor the decision “to make”:
 The quality of the product is decided to be controlled.
 If the purchase price is likely to rise due to increased demand in the market, it
becomes uneconomical to buy.

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 Where the technical know-how is to be kept secret and not to be passed on to the
suppliers and so on.
Example-1: Great Company manufactures 60, 000 units of part XL-40 each year for use
on its production line. The following are the costs of making part XL-40:
Total Costs Cost per
60, 000 units unit
Direct material Br. 480, 000 Br.8
Direct labor 360, 000 6
Variable factory overhead (FOH) 180, 000 3
Fixed FOH 360, 000 6
Total manufacturing costs Br.1, 380, 000 Br.23
Another manufacturer has offered to sell the same part to Great for Br.21 each. The
fixed overhead consists of depreciation, property taxes, insurance, and supervisory
salaries. The entire fixed overhead would continue if the Great Company bought the
component except that the cost of Br. 120, 000 pertaining to some supervisory and
custodial personnel could be avoided.

Instructions:
a) Should the parts be made or bought? Assume that the capacity now used to
make parts internally will become idle if the pats are purchased?
b) Assume that the capacity now used to make parts will be either (i) be rented to
near by manufacturer for Br. 60, 000 for the year or (ii) be used to make another
product that will yield a profit contribution of Br. 250,000 per year. Should the
company purchase them from the outside supplier?
Example-2: Assume that a division of Leranso Company makes an electric component
for its speakers. The management is trying to decide whether the division of the
company should manufacture this component part or purchase it from another
manufacturer.
The following are production costs for 100,000 units of the component for the forth-
coming year.
Direct material Br.500, 000
Direct labor 200,000
Factory overhead

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Indirect labor Br. 32,000
Supplies 90,000
Allocated occupancy costs 50,000 172,000
Total cost Br.872, 000
A small local company has offered to supply the components at a price of Br.7.80 each. If the
division discontinued the production of its components it would save two thirds of the supplies
cost and Br.22, 000 of indirect labor cost. All other overhead costs would continue regardless of
the decision made.

Instruction: Should the parts be made or bought? Assume that the capacity now used to
make the parts will become idle if they are purchased from outside.
Example-3: Assume thatthe following data relate to Muna Company to make 10,000
units of product-X.
Total cost Unit costs
Direct material---------------------------------------40,000 4
Direct labor-------------------------------------------160,000 16
FOH-Variable----------------------------------------80,000 8
FOH-Fixed ----------------------------------------160,000 16
Total----------------------------------------------------440,000 44
 An other manufacturer offers to sell Muna Company the same part for Br40 per
unit..
 Note that Br40, 000 of the fixed cost will be eliminated if the parts are bought
instead of made and released facilities will be left idle.
Required:Should the company make or buy the part?
 Assume that the released facilities can be used for other purposes say:
 In some activity to generate a contribution to profit of Br110, 000
 Renting out for Br70,000
Required: Which alternative is the best alternative?
Joint Product Decisions: Sell or Process Further
Often a firm manufactures several different products from a common input and a
common production process. In some cases of such multiple product processing, only
one product is of major importance. The other products are incidental to production.
For example, processing of log in a wood industry produces lumber and saw dust
where the latter is produced incidentally. In other cases, several products of comparable
value or importance emerge from a single process. For example, gasoline, jet fuel, and
lubricants all result from petroleum refining. The accountant classifies multiple

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products according to their relative importance. The principal product is called the
main product. Incidental products of lesser value are usually called by – products.
Products of nearly equal value are usually called joint products, or co-products.
When two or more manufactured products have relatively significant sales values and
are not separately identifiable as individual products until their split off, they are called
joint products.
 Split –off point- is the juncture in manufacturing where the joint products
become individually identifiable.
 The costs of manufacturing joint products before the split – off are called joint
costs. The costs of further processing beyond the split-off are separable costs.
Firms that produce several end products from a common input are faced with the
problem of deciding whether it is more advantageous to sell the products at split- off
point or process them further. When such a choice is available, managers must be
familiar with the relevant cost and revenue data to reach a correct decision.
Here, the decision whether to sell or process further will be taken by comparing the
additional cost of processing with the incremental revenue obtainable from the product
processed further. This decision will not be influenced either by the size of the joint cost
or the portion of the joint cost allocated to the product which is to be processed further.
Thus, joint product costs are irrelevant in decision regarding what to do with a product
from the split-off point forward, the joint product costs have already been incurred and
therefore are sunk costs. However, allocation of joint product costs is need for some
purposes, such as balance sheet inventory valuation. In case joint products are on hand
at the end of an accounting period, some value must be assigned to them. To do so, joint
product costs must be allocated to specific units of inventory.
 As a general rule, it will always be profitable to continue processing a joint
product after the split –off point so long as the incremental revenue from such
processing exceeds the incremental costs.

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Example-1: GREAT Co. uses a common direct material R that has a joint product cost of
Br. 16,000 and yields 6,000 pounds of product X selling for Br. 3 per pound and 4,000
pounds of product Y selling for Br. 3.50 per pound. Product X can be processed further
into XP at an additional cost of Br. 8,000, and product Y can be processed further into
YP at an additional cost of Br. 6,000. The new products, XP and YP, can then be sold for
Br. 4 and Br. 6 per pound, respectively.
Instruction: Which product (s) should be sold at split off and which should be sold after
processed further? Why? Assume no loss of input in further processing.
Example-2: UNITED Chemical Company produces three chemical products, x, y and z,
as a result of a particular joint process. The joint process cost is Br. 105,000. This
includes raw material costs and the cost of processing to the point where these joint
products go their separate ways. These products were processed further and sold as
follows:
CHEMICAL ADDITIONAL PROCESSING
PRODUCTS SALES COSTS
X Br. 260,000 Br. 220,000
Y 330,000 300,000
Z 175,000 100,000
The company has had an opportunity to sell at split-off directly to other processors. If
that alternative had been selected, sales would have been: X, Br. 56,000, Y, Br. 28,000
and Z, Br. 54,000.
The company expects to operate at the same level of production and sales in the forth-coming
year. Consider all the available information, and assume that all costs incurred after split-off are
variable.
Instruction:
a. Which products should be processed further and which should be sold at split-
off?
a. Could the company increase operating income by altering its processing
decisions? If so, what would be the expected overall operating income?

5.2.4. Keep or Replace Equipment Decisions

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Care must be taken to select only the data that are relevant for a decision whether to
replace or keep the old equipment. In such kind of decision, the book value of the old
equipment is not a relevant consideration, for instance.
In deciding whether to replace or keep existing equipment, four commonly encountered
items differ in relevance:
(i) Book value of old equipment: Irrelevant, because it is a past (historical) Cost.
Therefore, depreciation on old equipments irrelevant.
(ii) Disposal value of old equipment: Relevant, because it is an expected future
inflow that usually differs among alternatives.
(iii) Gain or loss on disposal: This is the algebraic difference between book value
and disposal value. It is therefore, a meaningless combination of irrelevant
and relevant items. Consequently, it is best to think of each separately.
(iv) Cost of new equipment: Relevant, because it is an expected future outflow
that will differ among alternatives. Therefore depreciation on new equipment
is relevant.
Example-1: Consider the data regarding Success co. photocopying requirements:
Old Proposed
Equipment Replacement
Equipment
Useful life, in years 5 3
Current age, in years 2 0
Useful life remaining, in years 3 3
Original cost Br. 25,000 Br. 15,000
Accumulated depreciation 10,000 0
Book value 15,000 Not acquired yet
Disposal value (in cash) now 3,000 Not acquired yet
Disposal value in 2 years 0 0
Annual cash operating costs for power,
maintenance, toner and supplies Br. 14,000 Br.7, 500

The administrator is trying to decide whether to replace the old equipment. Because of
rapid changes in technology, he expects the replacement equipment to have only a
three-year useful life. Ignore the effects of taxes.

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Instruction: Should SUCCESS keep or replace the old equipment? Compute the
difference in total cost over the next 3-years under both alternatives that is, keeping the
original or replacing it with the new machine.
Example-2: Awash Co. has just today paid for and installed a special machine for
polishing cars at one of its several outlets. It is the first day of the company's fiscal year.
The machine cost, Br. 20,000. Its annual cash operating costs total Br. 15,000, exclusive of
depreciation. The machine will have a 4-year useful life and a zero terminal disposal
price.
After the machine has been used for a day, a machine salesperson offers a different
machine that promises to do the same job at a yearly cash operating cost of Br. 9,000,
exclusive of depreciation. The new machine will cost Br. 24,000 cash, installed. The "old"
machine is unique and can be sold outright for only Br. 10,000 minus Br. 2000 removal
cost. The new machine, like the old one, will have a 4-year useful life and zero terminal
disposal prices.

Sales, all in cash, will be Br. 150,000 annually, and other cash costs will be Br. 110,000
annually, regardless of this decision.
Instructions:
(a) Prepare a summary income statement covering the next four years under both
alternatives (when the new machine is not purchased and when the new
machine is purchased). What is the cumulative difference in operating income
for the 4 years taken together?
(b) Determine the desirability of purchasing the new machine using only relevant
costs in your analysis?

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