a a aking: Relevant Costs and Benefis 7 al he managerial accountant. Th, , js by the managerial The lag. ures a special analysis ™ ose places in the organization's yj ffien will be found in many fon rea, 592 Chapter 14 Dein ns are made Over and over again, eyser ve decision v sitive _ Im conta, example, Worldwide Airways makes ru or imegular intervst ““guch a routine decision makes it worthy wales s ie are very ito Rep a special file ofthe information reer mane rial ac oe itive decisions typically ¢ “ay een of historia jan should be readily avalable. Information reeyagy P&S ee from those dec generate. THE rage comma Oy ws thought to deciding which daa are relevant an nels tsa go upon wich to base predictions. Importance of Identifying Relevant Costs and Benefits i to isolate the rel fant for the managerial accountant oma efits ina decision analysis? The reasons are twofold. First, generating infamy! costly process. The relevant data must be sought, and this reuies time an at focusing on only the relevant information, the managerial accountant can sing 2 shorten the data-gathering process. - i setSevond, people ean effectively use only @ limited amount of information, this, they experience information overload, and ther decision-making eget declines. By outnely providing only information about relevant costs and beni ‘managerial accountant can reduce the likelihood of information overload, Identifying Relevant Gosts and Benefits: To illustrate how managerial accountants determine relevant costs and benefits, we x) Leaninadhiedve 164 | consider several decisions faced by the management of Worldwide Airways, Bd ‘entity relevant costs andben- Atlanta, the airline flies routes between the United States and Europe, between varies fi, ig proper teamentto cities in Europe, and between the United States and several Asian cities, sunk ont, opportu costs, and ut cost Why is it import Sunk Costs Sunk costs are costs that have already been incurred. They do not affect any ft cx and cannot be changed by any current or future action. Sunk costs are irrelevant ods sions, as the following two examples show. Book Value of Equipment At Charles de Gaulle Airport in Pari, Worldwide At ‘ways has a three-year-old loader truck used to load in-flight meals onto apples. Tt box om the truck can be lifted hydraulically to the level of a jumbo jet's side doos. Tt ook value of this loader, defined as the asset's acquisition cost less the accu depreciation to date, is computed as follows: ‘Aenaion cost of loader ss: Aecumalstod depreciation BoC enn will be 2280 Bas one year of useful life remaining, after which it slgt = il be zero, However, it could be sold now for $5,000, In addition to they Chapter 14 Decson Making: Relovant Casts and Benes of $25,000, Worldwide Airways annuall os ale the loader. These include the ape is? eni02- 1, Worldwide Airways? ramp man oni ager at Charl : hn aout replacement of the loader. A new kind of ae a Airport, faces nto an airplane. The new loader is much cheaper aio mea ess operate However, the new loader would the old hydraulic er “4 would need to be replaced. Perti be operable ool fe it woul placed. Pert for onl ar befor nent data about the new loader are ag Yy incurs $80,000 in vari f operator labor, ironed oe allows eso ad $1500 aaron oo eos 15.000 jose 45.000 -¢ initial inclination is to continue usi msl’ inital ine © continue using the old loader for another gms We cant GUM that equipment now. We paid $100,000 for it, and ee io years We get id of that loader now, wel lose $20.00 id ee reasons thatthe sl loaders book value of $25,000, less is current aay ce CFso. amounts 2 1s of 20,000, smnatly, Orville’s comment s overheard by Joan Wilbur, the manager q tin the company’s Charles de Gaulle Airport administrative Sences Wibarptns nt eile tthe book vale ofthe ol oar a sun cont cannot fit any ae an pany might incur. To convince Orville that she is i ea Shown in Exhibit 14-2. eis right, Wilbur prepares the va less of which alternative is selected, the $25,000 book value of the old sxe an expense or loss in the next ear. Ifthe ol loader is kept in serves lu 000 will be recognized as depreciation expense; otherwise, the $25,000 cost i se ncured by the company as a write-off of the asset's book value. Thus, the wis ook value of the old Toader is sunk cost and irelevat tothe replacement decision. ouce that the relevant data in the equipment replacement decision ae items (3), (4), anit) Each of these items meets the two tests of relevant information: 1, The costs or benefits relate to the future. 2, The costs or benefits differ between the alternatives. item (3), will be received in the future only The proceeds from selling the old loader, under the “replace” alternative. Similarly, the acquisition cost (depreciation) of the new Exhibit 14-2 Costs of Two Altematves Eh 0 ) © Decision: Wordwide Always, ‘Do Not Replace Dierentiat ‘od Loaders old Loader" ost: (a) — (0) ei Airways sou {Dereon ofa acer 25,000 os on [aS an ena | 6) reeds om psf tor + ae 4 Depreciation (onst of new lsat nm a 6 Operating cx eoon0 oa cat se $105,000 soca erogenous me vmaLZTS “eotens owe aca towin ti 2Exhibit 14-3 Obsolete Inventory Decision: Worldwide Airways pride Airways roe loader, item (4), isa future cost incurred only under the “replace” alternative. The opera, ing cost, item (5), is also a future cost that differs between the two alternatives, 7 Chapter 14 Decision Making: Relevant Costs and Benefits Differential Costs Exhibit 14-2 includes a column entitled Differential Cosy differential cost is the difference in a cos item under two decision alternatives. The vy’ putation of differential costs is @ convenient way of summarizing the relative advance 6of one alternative over the other. John Orville can make a correct equipment-replacense™ decision in either of two ways: (1) by comparing the total cost of the two allemanen shown in columns (a) and (b) or 2) by focusing on the total diferential cos, shows column (c), which favors the “replacement” option. Cost of Inventory on Hand Never having taken a managerial accounting course jy college, John Orville slow to leam how to idemtfy sunk costs. The next week he poof, again, ‘The inventory of spare aircraft parts held by Worldwide Airways at Charles de Gaulle includes some obsolete parts originally costing $20,000. The company no longer uses the planes for which the parts were purchased. The obsolete parts include spare passenger seats, luggage racks, and galley equipment. The spare parts could be sold to another ain. line for $17,000, However, with some modifications, the obsolete parts could still be used in the company’s current fleet of aircraft. Using the modified parts would save World. wide Airways the cost of purchasing new parts for its airplanes, John Orville decides not to dispose of the obsolete parts, because doing so would entail a loss of $3,000, Orville reasons that thie $20,000 book value of the parts, ess the $17,000 proceeds from disposal, would result in a $3,000 loss on disposal. Joan Wilbur, the managerial accountant, comes to the rescue again, demonstrating that the right deci. sion is to dispose of the parts. Wilbur's analysis is shown in Exhibit 14-3. Notice that the book value of the obsolete inventory is a sunk cost. If the parts are ‘modified, the $20,000 book value will be an expense during the period when the parts are used. Otherwise, the $20,000 book value of the asset will be written off when the parts are sold. As a sunk cost, the book value of the obsolete inventory will not affect any future cash flow of the company. As the managerial accountant’s analysis reveals, the relevant data include the $17,000 proceeds from disposal, the $12,000 cost to modify the parts, and the $26,000 cost to buy new parts. All of these data meet the two tests of relevance: they affect future cash flows and they differ between the two alternatives. As Joan Wilbur’s analysis shows, World- wide Airways’ cost will be $3,000 less if the obsolete parts are sold and new parts are purchased. Costs of Two Alternatives @) © © Modity and Use Dispose of Differential Parse Partst ost: (3) ~ 0) Suk Book va of patient ok asset vale wen of whether parts are used or not... ‘$20,000 ‘$20,000 $ Proceeds from disposal of parts + (17,000) 17,000 Reant | Costtomadiy pas 12,000 a 12000 seta (Costnced tty new pars forcurent IR nnn 26.000 25,000 pee S200 pie ee “Src ots rh oes he ana in is eit, cats shown incurs ou witout pein. ‘Parentses dona cash ito nts caseplevant or Ireevant (1) Passenger revenue , est )CRID FENG nn 0,000 Fes’ @) Landing fee in San Francs ae (4s of apr gate acti a 2.000, (21,000) (4.000) seat (1.009 $292,000 avi op eet css robes Wt pace oe, veteran a wae irrelevant Future Costs and Benefits Worldwide Airways’ headquarters in Atlanta, Amy Earhart, manager of flight schedul- i isin the midst of making a decision about the Aanta to Honolul route. he flightis curently nonstop, but she is considering a stop in San Francisco. She feels that the route ‘would attract additional passengers if the stop is made, but there also would be additional rafable costs. Her analysis appears in Exhibit 14-4, The analysis indicates that the preferable alternative is the route that includes a stop in San Francisco. Notice that the cargo revenue [item (2)] and the aircraft maintenance cost item (8)] are irrelevant to the flight-route decision. Although these data do affect future cash flows, they do nor differ between the two alternatives. All ofthe other data in Enhibit 14-4 are relevant to the decision, because they do differ between the two alterna- tives. The analysis in Exhibit 14~4 could have ignored the irrelevant data; the same deci- sion would have been reached. (Exercise 14-30, at the end of the chapter, will ask you to prove this assertion by redoing the analysis without the irrelevant data.) Opportunity Costs ‘Another decision confronting Amy Earhart is whether to add two daily round-trip flights, between Atlanta and Montreal. Her initial analysis of the relevant costs and benefits indi- ‘ates that the additional revenue from the flights will exceed their costs by $30,000 per ‘nonth, Hence, she is ready to add the flights to the schedule. However, Chuck Lindbergh, Worldwide Airways’ hangar manager in Atlanta, points out that Earhart has overlooked rimportant consideration, Worldwide Airways currently has excess space in its hangar. A commuter airline ‘offered to rent the hangar space for $40,000 per month. However, if the Atlanta-to- ontreal flights are added to the schedule, the additional aircraft needed in Atlanta will "ati the excess hangar space. IWorldwide Airways adds the Atlanta-to-Montreal flights, it will forgo the oppor- [ity to rent the excess hangar space for $40,000 per month. Thus, the $40,000 in rent saone is an opportunity cost of the alternative to add the new flights. An ‘opportunity Sctis the potential benefit given up when the choice of one action precludes a different tion. Although people tend to overlook or underestimate the importance of opportunity, In we) ate just as relevant as out-of-pocket costs in evaluating decision alternatives. the wridWide Airways’ case, the best action is to rent the excess warehouse space (0 so, Commuter airline, rather than adding the new flights. The analysis in Exhibit 14-5 “PPOrt this conclusion. (ie AirwaysExhibit 14-5 Decision to Add Fights: Worldwide Airways mridwie Airways “1 wouid say that they fine managers] ew us 2s ‘business partners." (140) Boeing Chapter 14 Decision Making: Relevant Costs and Benefits kis bon ® At Fights anata Fights ny Akita revenue from new ighis ies adore ots. = 0000 o re Rental of excess hangar space... ES $40,000 , TO sam = s4aco a aie ao “Paenbeses cera tha eral tet fons oto Itis a common mistake for people to overlook or underweigh opportunity eggs $40,000 hangar rental, which will be forgone if the new flights are added, is an g nity cost ofthe option to add the flights Tt is a relevant cost ofthe decison and typ as important as any out-of-pocket expenditure. Summary Relevant costs and benefits satisfy the following two criteria: 1. They affect the future. 2. They differ between alternatives, Sunk costs are not relevant costs, because they do not affect the future. An example of a sunk cost is the book value of an asset, either equipment or inventory. Future cons or benefits that are identical across all decision alternatives are not relevant. They can be ignored when making a decision. Opportunity costs are relevant costs. Such cos, deserve particular attention because many people tend to overlook them when making decisions. Analysis of Special Deci ‘Leaming Objective 14-5 Prepare analyses of various special decisions, property Identtyng the relevant costs and benefis. ‘What are the relevant costs and benefits when a manager must decide whether to add or drop a product or service? What data are relevant when deciding whether to produce or buy a service or component? These decisions and certain other nonroutine decisions merit special attention in our discussion of relevant costs and benefits. Accept or Reject a Special Offer Jim Wright, Worldwide Airways’ vice president for operations, has been approached by a Japanese tourist agency about flying chartered tourist flights from Japan to Hawai. The tourist agency has offered Worldwide Airways $150,000 per round-trip flight on a jumbo jet. Given the airline’s usual occupancy rate and air fares, a round-trip jumbo-jet flight between Japan and Hawaii typically brings in revenue of $250,000. Thus, the tourist agency's specially priced offer requires a special analysis by Jim Wright. Wright knows that Worldwide Airways has two jumbo jets that are not currenty ia use, The airline has just eliminated several unprofitable routes, freeing these aircraft for other uses. The airline was not currently planning to add any new routes, and therefore the two jets were idle. To help make his decision, Wright asks for cost data from the com troller's office. The controller provides the information in Exhibit 14-6, which pertains © atypical round-trip jumbo-jet flight between Japan and Hawaii 5 The variable costs cover aircraft fuel and maintenance, flight-crew costs, in-Might meals and services, and landing fees. The fixed costs allocated to each flight cover World- wide Airways’ fixed costs, such as aircraft depreciation, maintenance and depreciation of facilites, and fixed administrative costs.yr Chapter 14 Decision Making: Relevant Costs and Benefits 597 eu —— ents arene 3 : Data for Typical Flight ome - ad Between Japan and Hava: Narcbl expenses ight snc Worldwide Airvays Fresereres aca a each fg > TIO EES nnn ce rl com orldwide Airways If Jim Wright had not underst, following incorrect analysis, yc ce fox hater eet pra ee Assumes cess Special price for charter ‘apacty ‘Variable cost per routine flight. 7 $90,000 =~ ie cat Less: Savings on reservations and ticketing 5000 ‘Variable cost of charter. : 85,000 Cinitutn fom charter nn $5000 Wright’s analysis shows that the special charter flight will contribute $65,000 toward covering the airline’s fixed costs and profit. Since the airline has excess flight capacity, due tothe existence of idle aircraft, the optimal decision is to accept the special charter offer. No Excess Capacity Now let’s consider how Wright's analysis would appear if Worldwide Airways had no idle aircraft. Suppose that in order to fly the charter between Japan and Hawaii, the airline would have to cancel its least profitable route, which is between Japan and Hong Kong. This route contributes $80,000 toward covering ihe a line's fixed costs and profit. Thus, ifthe charter offer is accepted, the aifne Wi Oe an opportunity cost of $80,000 from the forgone contribution of the Japan-Hon Foute. Now Wright's analysis should appear as shown below. ‘15,000 ke Socal ioe fr chat nn e000 Deve: Ya east per out ight 5,000 Less Savings on reservations and td ‘85.000 Variable cost of charter ve pt Opportunity xt fxg com encoo 165000 ‘on canceled Japan-Hong Kong U2 ver " = Ta Loss from chart.