Least Cost Decisions:

Revenues are not directly involved in some decisions. For example, a company that does not charge for delivery service may need to replace an old delivery truck, or a company may be trying to decide whether to lease or to buy its fleet of executive cars. In situations such as these, where no revenues are involved, the most desirable alternative will be the one that promises the least total cost from the present value perspective. Hence, these are known as least cost decisions. To illustrate a least cost decision, consider the following data:

Example:
Val-Tek Company is considering the replacement of an old threading machine. A new threading machine is available that could substantially reduce annual operating costs. Selected data relating to the old and the new machines are presented below:
Old Machine Purchase cost when new Salvage value now Annual cash operating costs Overhaul needed immediately Salvage value in six years Remaining life Val-Tek Company uses a 10% discount rate $200,000 30,000 150,000 40,000 0 6 years New Machine $250,000 -90,000 -50,000 6 years

Total Cost Approach or Total Cost Method:

Following is the analysis of the alternatives using total cost approach:

The Total Cost Approach (Lease Cost Decision)

Item Buy the new machine: Initial investment Salvage of the old machine Annual cash operating cost Salvage of the new machine Net present value Now Now 1-6 Now $(250,000) 30,000 (90,000) 50,000 1.000 1.000 4.355 0.564 $(250,000)** 30,000** (391,950) 28,200 583,750 Year(s) Amount of Cash Present Value of 10% Factor* Flows Cash Flows

Keep the old machine: Overhaul needed now Annual cash operating costs present value of net cash outflows Net present value in favor of buying the new machine Now 1-6 $(40,000) (150,000) 1.000 4.355 (40,000) (653,250) $693,250

$109,500

* All present value factors are from Future Value and Present Value Tables page - Table 3 and Table 4. ** These two figures could be netted into a single $220,000 incremental cost figure ($250,000 - $30,000 = $220,000)

As shown in the above solution, the new machine has the lowest total cost when the present value of the net cash outflow is considered.

Incremental Cost Approach or Incremental Cost Method:

An analysis of the two alternatives using the incremental cost approach is presented below:

The Incremental Cost Approach (Lease Cost Decision)

Item Incremental investment to buy the new machine Salvage of the old machine Salvage in annual cash operating costs Difference in salvage value in six years Net present value in favor of buying the new machine Year(s) Now Now 1-6 6 Amount of Cash Flows $(210,000) 30,000 60,000 50,000 10% Factor* 1.000 1.000 4.355 0.564 Present Value of Cash Flows $(210,000)** (30,000)** 261,300 28,200 $109,500

* All present value factors are from Future Value and Present Value Tables page - Table 3 and Table 4. ** These two items could be netted into a single $180,000 incremental cost figure ($210,000 - $30,000 = $180,000).

This solution represents the differences between the alternatives as shown under the total cost approach. In Business | Trading in that Old Car? Consumer reports magazine provides the following data concerning the alternatives of keeping a four year old Ford Taurus for three years or buying a similar new car to replace it. The illustration assumes the car would be purchased and used in suburban Chicago. Keep the Old Taurus $1,180 370 15 605 Buy a New Taurus $650 830 100 7,763 17,150

Annual maintenance Annual insurance Annual license Trade-in value in three years Purchase price, including sales tax

Consumer Reports is ordinarily extremely careful in its analysis, but it has omitted in this case one financial item that would clearly differ substantially between the alternatives and hence would be relevant. What is it?
Source: "When to Give Up on Your Clunker," Consumer Reports, August 2000, pp. 12-16.

Examples of Incremental Analysis

Incremental analysis, sometimes called marginal or differential analysis, is used to analyze the financial information needed for decision making. It identifies the relevant revenues and/or costs of each alternative and the expected impact of the alternative on future income. Here are some examples of incremental analysis:

Accepting additional business. Making or buying parts or products. Selling products or processing them further. Eliminating a segment. Allocating scarce resources (sales mix).

Accepting additional business

The Party Connection prepares complete party kits for various types of celebrations. It is currently operating at 75% of its capacity. It costs The Party Connection $4.50 to make a packet that it sells for $25.00. It currently makes and sells 84,000 packets per year. Detailed information follows: Per Unit Annual Total Sales Direct Materials Direct Labor Overhead Selling Expenses Administrative Expenses Total Costs and Expenses Operating Income $25.00 12.00 6.00 .50 1.75 .25 20.50 $ 4.50 $2,100,000 1,008,000 504,000 42,000 147,000 21,000 1,722,000 $378,000

The Party Connection has received a special order request for 15,000 packets at a price of $20 per packet to be shipped overseas. This transaction would not affect the company's current business. If 84,000 packets is 75% of capacity, 112,000 packets would be 100% of capacity. The Party Connection has the capacity to prepare the 15,000 packets requested without changing its existing operations. Should the Party Connection accept this special order? Using its current cost information, the answer would be no because accepting the order would generate a $7,500 loss. Per Unit Total

Sales Direct Materials Direct Labor Overhead Selling Expenses Administrative Expenses Total Costs and Expenses Operating Income

$20.00 12.00 6.00 .50 1.75 .25 20.50 $ (.50)

$300,000 180,000 90,000 7,500 26,250 3,750 307,500 $(7,500)

However, this is not the proper way to analyze the alternative. Incremental analysis, which identifies only those revenues and costs that change if the order were accepted, should be used to analyze the alternative. This requires a review of the costs. Suppose the following information is discovered with further analysis:

Accepting this order would not impact current sales. To manufacture 15,000 packets would require $12.00 of direct materials and $6.00 of direct labor. The per unit overhead cost of $0.50 is 50% variable ($0.25) and 50% fixed ($0.25). Selling costs (includes commissions and delivery costs) for the 15,000 packets would be $7,000. Administrative expenses would not change. Per Unit Sales Direct Materials Direct Labor Overhead Selling Expenses Total Costs and Expenses Operating Income $20.00 12.00 6.00 .25 Totals $300,000 180,000 90,000 3,750 7,000 280,750 $19,250

Under this scenario, $300,000 of additional revenues would be created with additional costs of $280,750, so operating income would increase by $19,250 if the order were accepted. Given the available capacity, this opportunity would not result in additional costs to expand capacity. If the current capacity were unable to handle the special request, any new costs for expanding capacity would be included in the analysis. Also, if current sales were impacted by this order, then the lost

contribution margin would be considered an opportunity cost for this alternative. With additional operating income of $19,250, this order could be accepted.