Opportunity Costs – An illustration

Papaya Mango Drink

Revenues $500,000
Costs:
Outlay costs 400,000
Financial benefit before opportunity costs $100,000
Opportunity cost of machine 60,000
Net financial benefit $ 40,000

Nantucket Nectars will gain $40,000 more financial benefit

using the machine to make Papaya Mango than it would make
using it for the next most profitable alternative.
 Make-or-Buy – An illustration

Nantucket Nectars Company’s Cost of Making 120ml Bottles

Direct material $ 60,000 $.06

Direct labor 20,000 .02
Variable factory overhead 40,000 .04
Fixed factory overhead 80,000 .08
Total costs $200,000 $.20

Another manufacturer offers to sell Nantucket Nectars the

bottles for $.18. Should Nantucket Nectars make or buy
the bottles?
 Make-or-Buy – An illustration
Perhaps Nantucket Nectars will eliminate $50,000 of fixed costs
if the company buys the bottles instead of making them.
For example, the company may be able to release a supervisor
with a $50,000 salary.

If the company buys the bottles, $50,000 of fixed overhead

would be eliminated.

Should Nantucket make or buy the bottles?

 Make-or-Buy – An illustration
Make Buy

Total Per Bottle Total Per Bottle

Purchase cost $180,000 $.18

Direct material $ 60,000 $.06
Direct labor 20,000 .02
Variable overhead 40,000 .04
Fixed OH avoided by
not making 50,000 .05 0 0
Total relevant costs $170,000 $.17 $180,000 $.18

Difference in favor
of making $ 10,000 $.01

*Note that unavoidable fixed costs of $80,000 – $50,000 = $30,000 are irrelevant.
Thus, the irrelevant costs per unit are $.08 – $.05 = $.03.
 Equipment Replacement – An illustration

Old Replacement
Machine Machine

Original cost $10,000 $8,000

Useful life in years 10 4
Current age in years 6 0
Useful life remaining in years 4 4
Accumulated depreciation $ 6,000 0
Book value $ 4,000 N/A
Disposal value (in cash) now $ 2,500 N/A
Disposal value in 4 years 0 0
Annual cash operating costs $ 5,000 $3,000
 Equipment Replacement – An illustration

Total for Four Years

Keep Replace Difference

Cash operating costs $20,000 $12,000 $8,000

Old equipment (book value):
Depreciation, or 4,000 – –
Lump-sum write-off – 4,000 –
Disposal value – (2,500) 2,500
New machine
acquisition cost – 8,000 (8,000)
Total costs $24,000 $21,500 $2,500