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13
Relevant Costs for
Decision Making
13-2
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Distinguish between relevant and irrelevant
costs in decisions.
2. Prepare an analysis showing whether to keep
or replace old equipment.
3. Prepare an analysis showing whether a
product line or other organizational segment
should be dropped or retained.
4. Prepare a well-organized make or buy
analysis.
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
5. Prepare an analysis showing whether a
special order should be accepted.
6. Determine the most profitable use of a
constrained resource.
7. Prepare an analysis showing whether joint
products should be sold at the split-off point
or processed further.
2
1
Incorrect Analysis
The manager recommends that the
company not purchase the new
machine since disposal of the old
machine would result in a loss:
Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000
Variable expenses (500,000)
Other fixed expenses
Amortization - new
Amortization - old
Disposal of old machine
Total net income
$200,000
$200,000 per
per year
year ×× 55 years
years
$100,000
$100,000 per
per year
year ×× 55 years
years
© McGraw-Hill Ryerson Limited., 2001
13-16
Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000
Variable expenses (500,000)
Other fixed expenses (350,000)
Amortization - new
Amortization - old
Disposal of old machine
Total net income
$70,000
$70,000 per
per year
year ×× 55 years
years
Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000
Variable expenses (500,000)
Other fixed expenses (350,000)
Amortization - new
Amortization - old (60,000)
Disposal of old machine
Total net income $ 90,000
The
Theremaining
remaining book
book
value
valueof
ofthe
theold
oldmachine.
machine.
© McGraw-Hill Ryerson Limited., 2001
13-18
Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000 $ 1,000,000 $ -
Variable expenses (500,000) (400,000) 100,000
Other fixed expenses (350,000)
Amortization - new
Amortization - old (60,000)
Disposal of old machine
Total net income $ 90,000
$80,000
$80,000 per
per year
year ×× 55 years
years
Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000 $ 1,000,000 $ -
Variable expenses (500,000) (400,000) 100,000
Other fixed expenses (350,000) (350,000) -
Amortization - new (90,000) (90,000)
Amortization - old (60,000)
Disposal of old machine
Total net income $ 90,000
The
The total
total cost
cost will
will be
be amortized
amortized
over
over the
the five
five year
year period.
period.
Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000 $ 1,000,000 $ -
Variable expenses (500,000) (400,000) 100,000
Other fixed expenses (350,000) (350,000) -
Amortization - new (90,000) (90,000)
Amortization - old (60,000) (60,000) -
Disposal of old machine 15,000 15,000
Total net income $ 90,000 $ 115,000 $ 25,000
Correct Analysis
Look at the comparative cost and revenue for the next
five years.
Purchase
Keep Old New
For Five Years Machine Machine Difference
Sales $ 1,000,000 $ 1,000,000 $ -
Variable expenses (500,000) (400,000) 100,000
Other fixed expenses (350,000) (350,000) -
Amortization - new (90,000) (90,000)
Amortization - old (60,000) (60,000) -
Disposal of old machine 15,000 15,000
Total net income $ 90,000 $ 115,000 $ 25,000
Correct Analysis
Let’s look at a
more efficient
way to analyze
this decision.
Correct Analysis
Net effect
Correct Analysis
Adding/Dropping Segments
Adding/Dropping Segments
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable mfg. 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
Amortization of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net loss $ (100,000)
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
IfIf the
Less: the digital
digital
variable watch
watch line
expenses line is
is dropped,
dropped, thethe
fixed
fixed
Variablegeneral
mfg. factory
general factory overhead
costs overhead and
and general
$ 120,000 general
Variable shippingexpenses
administrative costs will 5,000
administrative expenses will be
be allocated
allocated
Commissions 75,000 200,000
to other product
to othermargin
Contribution
lines because they
product lines because they$ 300,000
Less: fixed expensesare
are not
not avoidable.
avoidable.
General factory overhead $ 60,000
Salary of line manager 90,000
Amortization of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net loss $ (100,000)
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable mfg. costs $ 120,000
The
The equipment used to manufacture
equipment used to manufacture
Variable shipping costs 5,000
digital
digital watches
Commissions watches has
has no
no resale
resale
75,000 200,000
value or
or alternative
valuemargin
Contribution alternative use.
use. $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Amortization of equipment 50,000
Advertising - direct
Should Lovell
Should Lovell retain or drop
100,000 retain or drop
Rent - factory space the
the digital
digital watch
watch segment?
70,000 segment?
General admin. expenses 30,000 400,000
Net loss $ (100,000)
DECISION RULE
Lovell should drop the digital watch
segment only if its fixed cost savings
exceed lost contribution margin.
Remember,
Remember, amortization
amortization onon equipment
equipment with
with no no resale
resale
value
value is
is not
not relevant
relevant to
to the
the decision
decision since
since itit is
is aa sunk
sunk
cost
cost and
and is
is not
not avoidable.
avoidable.
Direct
Direct materials
materials $$ 99
Direct
Direct labour
labour 55
Variable
Variable overhead
overhead 11
Amortization
Amortization of of special
special equip.
equip. 33
Supervisor's
Supervisor'ssalary
salary 22
General
General factory
factory overhead
overhead 10
10
Total
Total cost
cost per
per unit
unit $$ 30
30
The
The special
special equipment
equipment hashas no
no resale
resale
value
value and
and is
is aa sunk
sunk cost.
cost.
Not
Not avoidable
avoidable and and is
is irrelevant.
irrelevant. IfIf the
the product
product is
is
dropped,
dropped, itit will
will be
be reallocated
reallocated toto other
other products.
products.
DECISION
DECISION RULERULE
In
In deciding
deciding whether
whether to
to accept
accept the
the outside
outside
supplier’s
supplier’s offer,
offer, Essex
Essex isolated
isolated the
the relevant
relevant
costs
costs of
of making
making the
the part
part by
by eliminating:
eliminating
eliminating:
$
$The
The sunk
sunk costs.
costs.
$
$The
The future
future costs
costs that
that will
will not
not differ
differ between
between
making
making or
or buying
buying the
the parts.
parts.
Special Orders
# Jet, Inc. receives a one-time order that is not
considered part of its normal ongoing business.
# Jet, Inc. makes a single product with a unit
variable cost of $8. Normal selling price is $20
per unit.
# A foreign distributor offers to purchase 3,000
units for $10 per unit.
# Annual capacity is 10,000 units, and annual
fixed costs total $48,000, but Jet, Inc. is
currently producing and selling only 5,000 units.
Should Jet accept the offer?
© McGraw-Hill Ryerson Limited., 2001
13-47
Special Orders
Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labour 5,000
Manufacturing overhead 10,000
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Total fixed costs 48,000
Net income $ 12,000
Special Orders
If
If there
there are
are no
no other
other considerations,
considerations, the
the best
best
plan
plan would
would be
be to
to produce
produce toto meet
meet current
current
demand
demand for
for Product
Product 22 and
and then
then use
use
remaining
remaining capacity
capacity to
to make
make Product
Product 1.
1.
Weekly
Weeklydemand
demandfor
for Product
Product 22 2,200
2,200 units
units
Time
Timerequired
requiredper
per unit
unit ×× 0.50
0.50 min.
min.
Total
Totaltime
timerequired
requiredtotomake
make
Product
Product22 1,100
1,100 min.
min.
Weekly
Weeklydemand
demandfor
for Product
Product 22 2,200
2,200 units
units
Time
Timerequired
requiredper
per unit
unit ×× 0.50
0.50 min.
min.
Total
Totaltime
timerequired
requiredtotomake
make
Product
Product22 1,100
1,100 min.
min.
Total
Totaltime
timeavailable
available 2,400
2,400 min.
min.
Time
Timeused
usedtotomake
makeProduct
Product 22 1,100
1,100 min.
min.
Time
Timeavailable
availablefor
for Product
Product11 1,300
1,300 min.
min.
Weekly
Weeklydemand
demandfor
for Product
Product 22 2,200
2,200 units
units
Time
Timerequired
requiredper
per unit
unit ×× 0.50
0.50 min.
min.
Total
Totaltime
timerequired
requiredtotomake
make
Product
Product22 1,100
1,100 min.
min.
Total
Totaltime
timeavailable
available 2,400
2,400 min.
min.
Time
Timeused
usedtotomake
makeProduct
Product 22 1,100
1,100 min.
min.
Time
Timeavailable
availablefor
for Product
Product11 1,300
1,300 min.
min.
Time
Timerequired
requiredper
per unit
unit ÷÷ 1.00
1.00 min.
min.
Production
Productionof ofProduct
Product11 1,300
1,300 units
units
Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000
Managing Constraints
Produce only
what can be sold.
Finding ways to At the bottleneck itself:
process more units
through a resource •Improve the process
bottleneck • Add overtime or another shift
• Hire new workers or acquire
more machines
• Subcontract production
Eliminate waste.
Streamline production process.
Joint Products
Joint
Costs Oil
Common
Joint
Production Gasoline
Input
Process
Chemicals
Split-Off
Point
Joint Products
Joint
Separate Final
Costs Oil
Processing Sale
Common
Joint Final
Production Gasoline
Input Sale
Process
Separate Final
Chemicals
Processing Sale
Split-Off Separate
Point Product
Costs
© McGraw-Hill Ryerson Limited., 2001
13-62
Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40
Sales value after further processing 270 50
Allocated joint product costs 176 24
Cost of further processing 50 20
Should
Should we
we process
process thethe lumber
lumber
further
further and
and sell
sell the
the sawdust
sawdust “as
“as is”?
is”?
End of Chapter 13