Managerial Accounting

CHAPTER 4
Relevant Information and Decision Making: Production Decisions

Opportunity, Outlay, and Differential costs

An opportunity cost is the contribution to income that is foregone (rejected) by not using
a limited resource in its next-best alternative use. Opportunity costs are not recorded in
formal accounting records since they do not generate cash outlays. These costs also are
not ordinarily incorporated into formal reports.
The opportunity cost of holding inventory is the income forgone from tying up money in
inventory and not investing it elsewhere.
An outlay cost requires a future cash disbursement.
Differential cost and incremental cost are defined as the difference in total cost between
two alternatives.

Example (opportunity cost)

A manufacturer predicts that 240,000 units of component X will have to be purchased
next year. The company estimates that 20,000 units will be required each month. A
supplier quotes a price of Br 8 per unit. The supplier also offers a special discount option:
If all 240,000 units are purchased at the start of the year, a discount of 5% off the price
will be given. The company can invest its cash at 8% per year. It costs the company Br
200 to place each purchase order.
1. What is the opportunity cost of interest forgone from purchasing all 240,000 units at
the start of the year instead of in 12 monthly purchases of 20,000 units per order?
2. Should the company purchase 240,000 units at the start of the year or 20,000 units
each month?
Alternative1 Alternative 2
Purchase all 240,000 units Purchase 20,000 units each
at the start of the year month
Unit cost 8 - 0.05(8) = Br 7.60 8
Average investment
in inventory = Highest inventory level + Lowest inventory level
2

= (240,000 + 0)7.60 = (20,000 + 0)8

2 2
= 912,000 = 80,000

Interest that could be earned if

investment in inventory were
invested at 8% return = 912,000 x .08 = 80,000 x .08
= Br 72,960 = Br 6,400

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1. Therefore the opportunity cost of interest forgone from purchasing all 240,000 units at
the start of the year instead of in 12 monthly purchases of 20,000 units per order is
Br66,560 (72,960 -6,4000)

2.
Alternative 1 Alternative 2
Total purchase order costs Br 200 Br 200 x 12 =Br 2,400
Total purchase costs 240,000 x 7.60 240,000 x 8
= Br 1,824,000 = Br 1,920,000
Interest foregone = Br 72,960 = Br6, 400

Total relevant costs 1,897,160 1,928,800

Make-or-Buy Decisions
The basic make-or-buy question is whether a company should make its own parts to be
used in its products or buy them from vendors. In making such decisions, qualitative and
quantitative factors are usually taken in to account.

Qualitative Factors

A firm may prefer to buy parts for ensuring smooth flow of parts and materials. For
example, a strike against a major parts supplier might cause operations to be interrupted.
Also many firms feel that they can control quality better by producing their own parts and
materials, rather than by relying on the quality control standards of outside suppliers. In
addition, the firm realizes profits from the parts and materials that it is making rather than
buying as well as profits from its regular operations.

The advantages of making parts, however, are counterbalanced by a number of hazards.

A firm that produces all of its own parts runs he risk of destroying long-run relationships
with suppliers, which may prove harmful and disruptive to the firm. Once relationships
with suppliers have been severed, they are difficult to reestablish. If product demand
becomes heavy, a firm may not have sufficient capacity to continue producing all of its
own parts internally and may experience great difficult in its efforts to secure assistance
from a severed supplier.

Example
Suppose an executive is trying to decide whether his company should continue to
manufacture an engine component or purchase it from a vendor for Br. 52 each. Demand
for the coming year is expected to be the same as for the current year, 200,000 units.
Data for the current year follow:

Direct material Br.5, 000,000

Direct labor 1,900,000
Variable factory overhead 1,100,000
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Fixed factory overhead 2,500,000
Total costs 10,500,000

If the company makes the components, the unit costs of direct material will increase
10%.If the company buys the component, 40% of the fixed costs will be avoided.
Assume variable overhead varies with output volume. Should the company make or buy
the component? Consider each of the following assumptions
a. The capacity to make the components will become idle if the components are
purchased.
b. The idle capacity can be rented to a local firm for Br.1, 250,000 for the coming year.

a.

Make Buy
Total per Unit Total per Unit
Purchase cost Br.10,400,000 Br.52
Direct material (110%) Br.5,500,000 27.50
Direct labor 1,900,000 9.50
Variable factory overhead 1,100,000 5.50
Fixed OH avoided
by not making (40%) 1,000,000 5
Total relevant costs Br.9,500,000 Br.47.5 10,400,000 Br.52
Difference in favor of makingBr.900,000 Br. 4.5

That is the cost that can be saved by not making will not be sufficient for purchasing the
engine parts from a supplier. Hence it is better to make the parts.

b. Buy and leave

Make the capacity idle Buy and Rent
9,500,000 10,400,000 10,400,000-1,250,000
= 9,150,000

If the capacity is rented, the cost that can be saved by not making will exceed the cost of
acquiring the parts by Br.350, 000(9,500,000-9,150,000).Therefore the company should
buy the parts.

Joint Product costs

Joint products are two or more manufactured products that have relatively significant
sales value and are not separately identifiable as individual products until their split-off
point. The split-off point is that juncture of manufacturing where the joint products
become individually identifiable. Joint costs are the costs of manufacturing joint products
before the split-off point. Separable costs are any costs incurred beyond the split-off
point.

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Example
A chemical Company produced three joint products at a joint cost of Br.120, 000.These
products were processed further and sold as follows.

Chemical product Sales Additional processing costs

A 230,000 190,000
B 330,000 300,000
C 175,000 100,000
The company has had the opportunity to sell at split-off directly to other processors. If
that alternative had been chosen, sales would have been A, Br.54,000; B, Br.28,000; and
C, Br. 54,000.The Company expects to operate at the same level of production and sales
in the forthcoming year. Consider all the available information, and assume that all costs
incurred after split-off are variable.
1. Could the company increase operating income by altering its processing decisions? If
so, what would be the expected overall operating income?
2. Which products should be processed further and which should be sold at split-off?

1.
Operating income after further processing= (230,000+330,000+175,000) –
(120,000+190,000+300,000+100,000) =735,000 -710,000 = 25,000

Operating income at split off point = (54,000+28,000+54,000) -120,000 =136,000-

120,000 =16,000

The operating income will be lower by 9,000(25,000-16,000) if the products are sold at
the split-off point.

Product
A B C
Final sales value 230,000 330,000 175,000
Sales value at splitoff 54,000 28,000 54,000
Incremental revenue 176,000 302,000 121,000
Incremental cost 190,000 300,000 100,000
(14,000) 2,000 21,000

A should be sold at split-off point whereas Band C should be processed further.

Note that the joint cost (Br.120,000) is irrelevant for the sell or process further decision.

Irrelevance of Past Costs

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One of the most difficult conceptual lessons that managers have to learn is that sunk costs
(past costs) are never relevant in decisions. The tendency to want to include sunk costs
with in the decision framework is especially strong in the case of book value of old
equipment. Regardless of their kind sunk costs are unavoidable and must be eliminated
from the manager’s decision framework.
Irrelevance of
Obsolete Inventory

Suppose General Dynamics has 100 obsolete aircraft parts in its inventory. The original
manufacturing cost of these parts was Br.100,000.

General Dynamics can

1. Remachine the parts for Br.30,000 and then sell them for Br.50,000, or
2. Scrap them for Br.5,000.

Which should it do?

Remachine Scrap Difference
Expected future revenue Br. 50,000 Br.5,000 Br.45,000
Expected future costs 30,000 0 30,000
Excess of revenue over costs Br.20,000 Br.5,000 Br.15,000
Inventory cost 100,000 100,000 0
Net overall loss on project. Br (80,000) Br.(95,000) Br.15,000

The inventory cost has already been incurred and is irrelevant to the decision. The parts
better be remachined and sold.

Irrelevance of Book Value

of Old Equipment
Three years ago a company bought a machine for Br. 8,000 .A salesman has suggested to
the company’s manager that she replace the machine with a new ,Br.12,500 machine. The
manager has gathered the following data
Old machine New machine
Original cost Br.8,000 Br. 12,500
Useful life in years 8 5
Current age in years 3 0
Useful life remaining in years 5 5
Accumulated depreciation Br. 3,000 Not acquired
Book value 5,000 Not acquired
Disposal value (in cash now) 2,000 Not acquired
Disposal value in 5 years 0 0
Annual cash operating cost Br.4,500 Br.2,000

Keep Replace
Cash operating cost (for 5 years) 22,500 10,000
Disposal value of old machine - -2,000
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Acquisition cost of the new machine - 12,500
Total relevant costs 22,500 20,500

Replace the machine since the associated relevant costs are lower than those for keeping
the machine.
As the above analysis showed depreciation relating to the book value of old equipment is
not a relevant cost in decision making. But don’t leap to a conclusion that depreciation of
any kind is irrelevant in the decision making process. Depreciation is irrelevant in
decisions only if it relates to a sunk cost. In addition disposal value of an existing will be
relevant in any decision that involves disposing of the asset.

Irrelevance of future costs that will not differ

If a future cost doesn’t differ among the alternatives being considered, the cost is
irrelevant to the decision to be taken. Do not assume that all variable costs are relevant
and all fixed costs are irrelevant. Variable costs are irrelevant whenever they don’t differ
among the alternatives at hand, and fixed costs are relevant whenever they differ between
the alternatives on at hand.

Caution in using unit costs

Unit costs must be analyzed with care in decision making. Use total costs rather than unit
costs. Then, if desired, the totals may be unitized.

Example
Assume that a new Br.100,000 machine with a five-year lifespan can produce 100,000
units a year at a variable cost of Br. 1 per unit, as opposed to a variable cost of Br 1.50
per unit with an old machine. A sales representative claims that the new machine will
reduce cost by Br.0.30 per unit. Is the new machine a worthwhile acquisition?
Old Machine New machine
Units 100,000 100,000
Variable costs 150,000 100,000
Straight line depreciation - 20,000
Total relevant costs 150,000 120,000
Unit relevant costs Br.1.50 Br.1.20

Acquiring the new machine will decrease unit cost by Br. 0.30 (1.50-1.30).

Assume the units expected to be produced are 30,000.

Old Machine New machine

Units 30,000 30,000
Variable costs 45,000 30,000
Straight line depreciation - 20,000
Total relevant costs 45,000 50,000
Unit relevant costs Br.1.50 Br.1.6667
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For production of 30,000 units, it is better to continue using the old machine.

Conflicts between decision making and performance evaluation

If the method used to evaluate performance of managers is inconsistent with the decision
model, managers may take poor decision if it maximizes their measure of performance.

Consider the following data used for replacement decision..

Old machine New machine

Original cost Br.8,000 Br. 12,500
Useful life in years 8 5
Current age in years 3 0
Accumulated depreciation Br. 3,000 Not acquired
Disposal value (in cash now) 2,000 Not acquired
Disposal value in 5 years 0 0
Annual cash operating cost Br.4,500 Br.2,000

Keep Replace
Cash operating cost (for 5 years) 22,500 10,000
Disposal value of old machine - -2,000
Acquisition cost of the new machine - 12,500
Total relevant costs 22,500 20,500

Year1_______ Years 2, 3, and 4

Keep Replace Keep Replace
Cash operating cost 4,500 2,000 4,500 2,000
Depreciation 1,000 2,500 1,000 2,500
Loss on disposal - 3,000 - -___
Total charges against revenue 5,500 7,500 5,500 4,500

If accounting income is used as a measure for judging the performance of the manager,
the manger may decide to keep the machine to maximize income in the frist year.

Inventory costing methods

The net income figure that is reported in the income statement captures the attention of
managers in a way few other numbers do. This is because of the manifold purpose for
which this figure is used such as evaluation of the performance of managers and the
analysis of the profitability of a proposed plan of action.
In this chapter we are going to see inventory costing choices that affect the reported
income of manufacturing companies.

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Variable costing is a method of inventory costing in which all variable manufacturing
costs are included as inventoriable costs. All fixed manufacturing costs are excluded
from inventoriable costs; fixed manufacturing costs are instead treated as costs of the
period in which they are incurred. Remember that inventoriable costs are all costs of a
product that are regarded as assets when they are incurred and expensed as cost of goods
sold when the product is sold.
Absorption costing is a method of inventory costing in which all-variable manufacturing
costs and all fixed manufacturing costs are included as inventoriable costs. That is,
inventory ''absorbs'' all manufacturing costs.

Under both variable costing and absorption costing all variable manufacturing costs are
inventoriable costs and all nonmanufacturing costs (whether variable or fixed), are costs
of the period and recorded as expenses when incurred.

The accounting for fixed manufacturing costs is the main difference between variable
costing and absorption costing.

 Under variable costing, fixed manufacturing costs are treated as an expense of the
period
 Under absorption costing, fixed manufacturing costs are inventoriable costs.

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