CHAPTER 16

Cost Analysis for Decision Making

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Decision Making
Strategic,
Operational,
and Financial
Planning
Planning and control cycle
Executing
operational
activities
(Managing)
Data collection and
performance feedback
Performance
analysis:
Plans vs.
actual results
(Controlling)
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A relevant cost is a future cost that
differs between alternatives.
Relevant Cost Information
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Will you drive or fly to Colorado for an eight-day spring
break ski trip?
You have gathered the following information to help you with
the decision.
Motel cost is $90 per night.
Meal cost is $25 per day.
Your car insurance is $75 per month.
Kennel cost for your dog is $7 per day.
Round-trip cost of gasoline for your car is $200.
Round-trip airfare and rental car for a week is $700.
Driving requires two days, with an overnight stay, cutting your
time in Colorado by two days.
Relevant Cost Information
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Colorado Spring Break
Drive/Fly Analysis
Cost Drive Fly
Motel 720 $ 720 $
Eating out costs 200 200
Kennel cost 56 56
Car insurance 75 75
Gasoline 200 -
Airfare/rental car - 700
8 days @ $90
8 days @ $25
8 days @ $7
Relevant Cost Information
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Costs do not differ,
so they are not
relevant to decision.
Also, car insurance
is not relevant to
the decision as it
is a past cost.
Relevant Cost Information
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Transportation
costs differ between
the two alternatives,
so they are relevant
to your decision
Are the two extra
days in Colorado
worth the $500
extra cost to fly?
Colorado Spring Break
Drive/Fly Analysis
Cost Drive Fly
Motel 720 $ 720 $
Eating out costs 200 200
Kennel cost 56 56
Car insurance 75 75
Gasoline 200 -
Airfare/rental car - 700
Relevant Cost Information
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Relevant Cost Information
Relevant Irrelevant
Differential Cost -- will differ Allocated Cost -- a common cost that
according to alternative activities has been arbitrarily assigned to a
being considered. product or activity.
Opportunity Cost -- income foregone Sunk Cost -- has already been incurred
by choosing one alternative over and will not change.
another.
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Example: If you were not
attending college, you could
be earning $20,000 per year.
Your opportunity cost of
attending college for one
year is $20,000.
Opportunity costs are not recorded in the
accounting records, but are relevant to
decisions because they are a real sacrifice.
Opportunity Cost
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The decision to accept additional
business should be based on incremental
costs and incremental revenues.
Incremental amounts are those that
occur if the company decides to accept
the new business.
The Special Pricing Decision
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MicroTech currently sells 4,400 laptop
computers. The company has revenue
and expenses as shown below:
Per Unit Total
Sales 2,400 $ 10,560,000 $
Direct materials 800 $ 3,520,000 $
Direct labor 450 1,980,000
Variable overhead 250 1,100,000
Fixed overhead 500 2,500,000
Total manufacturing cost 2,000 $ 9,100,000 $
Sales commission 120 528,000
Total expenses 2,120 $ 9,628,000 $
Operating income 280 $ 932,000 $
The Special Pricing Decision
Based on capacity of 5,000 units:
$2,500,000 5,000 units = $500 per
unit.
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MicroTech receives an offer to purchase
500 of its laptop computers for $1,800 each.
If MicroTech accepts the offer, total fixed
overhead will not increase and a selling
commission will not be paid on the computers
in the special order.
Should MicroTech accept the offer?
The Special Pricing Decision
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First lets look at incorrect reasoning
that leads to an incorrect decision.
Our manufacturing cost
is $2,000 per unit. I
cant sell for $1,800
per unit.
The Special Pricing Decision
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Current
Business
Special
Order

Combined
Sales 10,560 $ 900 $ 11,460 $
Direct materials 3,520 $ 400 $ 3,920 $
Direct labor 1,980 225 2,205
Variable overhead 1,100 125 1,225
Fixed overhead 2,500 0 2,500
Total manufacturing costs 9,100 $ 750 $ 9,850 $
Sales commission 528 0 528
Total expenses 9,628 $ 750 $ 10,378 $
Operating income 932 $ 150 $ 1,082 $
This analysis leads to the correct decision.
The Special Pricing Decision
000s omitted from all numbers.
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Current
Business
Special
Order

Combined
Sales 10,560 $ 900 $ 11,460 $
Direct materials 3,520 $ 400 $ 3,920 $
Direct labor 1,980 225 2,205
Variable overhead 1,100 125 1,225
Fixed overhead 2,500 0 2,500
Total manufacturing costs 9,100 $ 750 $ 9,850 $
Sales commission 528 0 528
Total expenses 9,628 $ 750 $ 10,378 $
Operating income 932 $ 150 $ 1,082 $
The Special Pricing Decision
500 new units $800 = $400,000
500 new units $1,800 selling price = $900,000
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Current
Business
Special
Order

Combined
Sales 10,560 $ 900 $ 11,460 $
Direct materials 3,520 $ 400 $ 3,920 $
Direct labor 1,980 225 2,205
Variable overhead 1,100 125 1,225
Fixed overhead 2,500 0 2,500
Total manufacturing costs 9,100 $ 750 $ 9,850 $
Sales commission 528 0 528
Total expenses 9,628 $ 750 $ 10,378 $
Operating income 932 $ 150 $ 1,082 $
500 new units $450 = $225,000
The Special Pricing Decision
500 new units $250 = $125,000
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Current
Business
Special
Order

Combined
Sales 10,560 $ 900 $ 11,460 $
Direct materials 3,520 $ 400 $ 3,920 $
Direct labor 1,980 225 2,205
Variable overhead 1,100 125 1,225
Fixed overhead 2,500 0 2,500
Total manufacturing costs 9,100 $ 750 $ 9,850 $
Sales commission 528 0 528
Total expenses 9,628 $ 750 $ 10,378 $
Operating income 932 $ 150 $ 1,082 $
Even though the $1,800 selling price is less than the
normal $2,400 selling price, MicroTech should accept the
offer because net income will increase by $150,000.
The Special Pricing Decision
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If MicroTech accepts the offer, net
income will increase by $150,000.
Increase in revenue (500 $1,800) 900,000 $
Increase in variable costs (500 $1,500) 750,000
Increase in net income
150,000 $
We can reach the same results more quickly like this:

Special order contribution margin = $1,800 $1,500 = $300
Change in income = $300 500 units = $150,000.
The Special Pricing Decision
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Should I
continue to make
the part, or should
I buy it?
What will I
do with my
idle facilities if
I buy the part?
The Make or Buy Decision
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The Make or Buy Decision
The relevant cost of making a component
is the cost that can be avoided by buying
the component from an outside supplier.
Decision rule: Costs avoided must be
greater than outside suppliers price to
consider buying the component.
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MicroTech currently makes the motherboards
used in its laptop computers. Unit cost for
manufacturing the motherboards are:
Unit Costs
Direct Material 120 $
Direct Labor 80
Variable Overhead 50
Fixed Overhead 100
Total 350 $
The Make or Buy Decision
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An outside supplier has offered to provide
the motherboards at a cost of $300 each
plus a $5 shipping charge per motherboard.
Twenty percent of the fixed overhead will be
avoided if the motherboards are purchased.
MicroTech has no alternative use for the
facilities.
Should MicroTech accept the offer?
The Make or Buy Decision
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Unit Cost
Direct Material 120 $
Direct Labor 80
Variable Overhead 50
Fixed Overhead (20% of $100) 20
Total 270 $
Differential costs of making (costs avoided if
bought from outside supplier):
The Make or Buy Decision
MicroTech should not pay $305 per unit to an outside
supplier to avoid the $270 per unit differential cost of
making the part ($35 disadvantage).
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If MicroTech buys the motherboards from
the outside supplier, the idle facilities
could be used to expand production of
flat screen monitors that have a
contribution margin of $50 each.
Does this information change MicroTechs
decision?
The Make or Buy Decision
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The real question to answer is,
What is the best use of MicroTechs facilities?
Disadvantage of buying ( $305 - $270 ) 35 $
Opportunity cost of facilities:
Monitor contribution margin 50
Advantage of buying part 15 $
The opportunity cost of facilities changes the decision.
The Make or Buy Decision
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Managers often face the problem of deciding
how scarce resources are going to be utilized.
Usually, fixed costs are not affected by this
particular decision, so management can focus
on maximizing total contribution margin.

Short-Term Allocation
of Scarce Resources
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Integrated Technologies produces two products
and selected data is shown below:
Products
1
2
Selling price per unit $ 300 $ 200
Less: variable expenses per unit 150 100
Contribution margin per unit
150 $ 100 $
Processing time required (hours) 2 1
Short-Term Allocation
of Scarce Resources
If 120 hours of processing time are available,
which product should be produced?
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Lets calculate the contribution margin
per hour of processing time.
Products
1
2
Contribution margin per unit $ 150 $ 100
Time required to produce one unit 2 hours 1 hour
Contribution margin per hour
75 $ 100 $
Short-Term Allocation
of Scarce Resources
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Lets calculate the contribution margin
per hour of processing time.
Products
1
2
Contribution margin per unit $ 150 $ 100
Time required to produce one unit 2 hours 1 hour
Contribution margin per hour
75 $ 100 $
Short-Term Allocation
of Scarce Resources
Product 2 should be emphasized. It is the more
valuable use of processing time, yielding a contribution
margin of $100 per hour as opposed to $75 per hour
for Product 1.
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Lets calculate the contribution margin
per hour of processing time.
Products
1
2
Contribution margin per unit $ 150 $ 100
Time required to produce one unit 2 hours 1 hour
Contribution margin per hour
75 $ 100 $
Short-Term Allocation
of Scarce Resources
If there are no other considerations, the best plan would
be to produce to meet current demand for Product 2 and
then use any time that remains to make Product 1.
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Let s
change
topics.
Long-Run Investment Decisions
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Capital Budgeting
How managers plan significant outlays on
projects that have long-term implications
such as the purchase of new equipment
and introduction of new products.
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Capital budgeting:
Analyzing alternative long-
term investments and deciding
which assets to acquire or sell.
Outcome
is uncertain.
Large amounts of
money are usually
involved.
Investment involves a
long-term commitment.
Decision may be
difficult or impossible
to reverse.
Capital Budgeting
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?
?
?
Limited
Investment
Funds
Plant
Expansion
New
Equipment
Office
Renovation
I will choose the
project with the most
profitable return on
available funds.
Investment Decision Special
Considerations
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Business investments
extend over long periods
of time, so we must
recognize the time value
of money.
Investments that
promise returns earlier
in time are preferable to
those that promise
returns later in time.
Investment Decision Special
Considerations
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The firms cost of capital is
usually regarded as the most
appropriate choice for the
discount rate to determine
the present value of the
investment proposal
being analyzed.
The cost of capital is the
average rate of return the
company must pay to its long-
term creditors and stockholders
for the use of their funds.
Cost of Capital
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Capital Budgeting Techniques
Methods that use present value analysis:
Net present value (NPV).
Internal rate of return (IRR).
Methods that do not use present value analysis:
Payback.
Accounting rate of return.
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A comparison of the present value of
cash inflows with the present value of
cash outflows
Net Present Value (NPV)
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Chose a discount rate the
minimum required rate of return.
Calculate the present
value of cash inflows.
Calculate the present
value of cash outflows.
NPV =
Net Present Value (NPV)
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General decision rule . . .
If the Net Present
Value is . . . Then the Project is . . .
Positive . . .
Acceptable, since it promises a
return greater than the cost of
capital.
Zero . . .
Acceptable, since it promises a
return equal to the cost of
capital.
Negative . . .
Not acceptable, since it
promises a return less than the
cost of capital.
Net Present Value (NPV)
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BoxMover, Inc. is considering the purchase
of a conveyor costing $16,000 with a 7-year
useful life and a $5,000 salvage value that
promises annual net cash flows as shown in
the following table. BoxMovers cost of
capital is 12 percent. Ignoring taxes,
compute the NPV for this investment.
Net Present Value
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Year
Annual Net
Cash Flows
Present
Value of $1
Factor
Present
Value of
Cash Flows
1 4,000 $ 0.89286 3,571 $
2 4,200 0.79719 3,348
3 4,200 0.71178 2,989
4 4,400 0.63552 2,796
5 4,800 0.56743 2,724
6 4,000 0.50663 2,027
7 3,800 0.45235 1,719
salvage 5,000 0.45235 2,262
Total 34,400 $ 21,436 $
Amount to be invested (16,000)
Net present value of investment 5,436 $
Net Present Value
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Year
Annual Net
Cash Flows
Present
Value of $1
Factor
Present
Value of
Cash Flows
1 4,000 $ 0.89286 3,571 $
2 4,200 0.79719 3,348
3 4,200 0.71178 2,989
4 4,400 0.63552 2,796
5 4,800 0.56743 2,724
6 4,000 0.50663 2,027
7 3,800 0.45235 1,719
salvage 5,000 0.45235 2,262
Total 34,400 $ 21,436 $
Amount to be invested (16,000)
Net present value of investment 5,436 $
Present value factors
for 12 percent
Net Present Value
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Year
Annual Net
Cash Flows
Present
Value of $1
Factor
Present
Value of
Cash Flows
1 4,000 $ 0.89286 3,571 $
2 4,200 0.79719 3,348
3 4,200 0.71178 2,989
4 4,400 0.63552 2,796
5 4,800 0.56743 2,724
6 4,000 0.50663 2,027
7 3,800 0.45235 1,719
salvage 5,000 0.45235 2,262
Total 34,400 $ 21,436 $
Amount to be invested (16,000)
Net present value of investment 5,436 $
A positive net present value indicates that this
project earns more than 12 percent, so the
investment should be made.
Net Present Value
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Brown Company can buy a new machine for
$96,000 that will save $20,000 cash per year in
operating costs. If the machine has a useful life of
10 years and Browns cost of capital return is 12
percent, what is the NPV? Ignore taxes.

a. $ 4,300
b. $12,700
c. $11,000
d. $17,000
Net Present Value (NPV)
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Brown Company can buy a new machine for
$96,000 that will save $20,000 cash per year in
operating costs. If the machine has a useful life of
10 years and Browns cost of capital return is 12
percent, what is the NPV? Ignore taxes.

a. $ 4,300
b. $12,700
c. $11,000
d. $17,000
Using the present value of an annuity
PV of inflows = $20,000 5.650 = $113,000
NPV = $113,000 - $96,000 = $17,000
Net Present Value (NPV)
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Calculate the NPV if Brown Companys cost of
capital is 15 percent instead of 12 percent.


Note that the NPV is smaller
using the larger interest rate.
Using the present value of an annuity
PV of inflows = $20,000 5.019 = $100,380
NPV = $100,380 - $96,000 = $4,380
Net Present Value (NPV)
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Ranking Investment Projects
Profitability Present value of cash inflows
index Investment required
=
A B
Present value of cash inflows $81,000 $6,000
Investment required 80,000 5,000
Profitability index 1.01 1.20
Investment
The higher the profitability index, the
more desirable the project.
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The actual rate of return that will be
earned by a proposed investment.
The interest rate that equates the present
value of inflows and outflows from an
investment project the discount rate at
which NPV = 0.
Internal Rate of Return (IRR)
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Decker Company can purchase a new
machine at a cost of $104,320 that will save
$20,000 per year in cash operating costs.
The machine has a 10-year life.
Internal Rate of Return (IRR)
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Future cash flows are the same every
year in this example, so we can
calculate the internal rate of return as
follows:
Investment required
Net annual cash flows
PV factor for the
internal rate of return
=
$104, 320
$20,000
= 5.216
Internal Rate of Return (IRR)
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Find the 10-period row, move
across until you find the factor
5.216. Look at the top of the column
and you find a rate of 14%.
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 1.736 1.690 1.647
. . . . . . . . . . . .
9 5.759 5.328 4.946
10 6.145 5.650 5.216
Using the present value of an annuity of $1 table . . .
Internal Rate of Return (IRR)
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Decker Company can purchase a new
machine at a cost of $104,320 that will save
$20,000 per year in cash operating costs.
The machine has a 10-year life.
Internal Rate of Return (IRR)
The internal rate of return on
this project is 14%.
If the internal rate of return is equal to
or greater than the companys required
rate of return, the project is acceptable.
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If cash inflows are unequal, trial and error
solution will result if present value tables
are used.
Sophisticated business calculators and
electronic spreadsheets can be used to
easily solve these problems.
Internal Rate of Return (IRR)
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Some Analytical Considerations
Sensitivity analysis and post audits are
helpful in dealing with estimates.
Cash flows far into the future are often not
considered because of uncertainty and a
small impact on present values.
Cash flows are assumed to occur
at the end of the year.
Some projects will require additional
investments over time.
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Some Analytical Considerations
Often, after-tax cash flow can be estimated by
adding depreciation to income.
Increased working capital is initially treated as
an additional investment (cash outflow) and
as a cash inflow if recovered at
the end of the projects life.
Least cost projects, often required
by law, will have negative NPVs.
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Jones company is considering purchasing a
machine with a 5-year life and $5,000 salvage value.
Cost and revenue information
Cost of machine
$ 55,000
Revenue 76,000 $
Cost of goods sold 50,000
Gross profit 26,000 $
Cash operating costs 5,000 $
Depreciation 10,000 15,000
Pretax income 11,000 $
Income tax 4,400
After-tax income 6,600 $
($55,000 - $5,000) 5 years
Some Analytical Considerations
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Most capital budgeting techniques use
annual net cash flow.

Depreciation is not a cash outflow.
Annual net income 6,600 $
Add annual depreciation 10,000
Annual net cash flow 16,600 $
Some Analytical Considerations
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Payback Period
The payback period of an investment
is the number of years it will take to
recover the amount of the investment.
Managers prefer investing in projects
with shorter payback periods.
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TexCo wants to
install a machine
that costs $17,000
and has an 8-year
useful life with
$1,000 salvage
value. Annual net
cash flows are:
Year
Annual Net
Cash Flows
Cumulative
Net Cash
Flows
0 (17,000) $ (17,000) $
1 4,000 (13,000)
2 3,500 (9,500)
3 3,500 (6,000)
4 3,500 (2,500)
5 3,500 1,000
6 3,500 4,500
7 3,000 7,500
8 3,000 10,500
Payback Period
Includes salvage
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Year
Annual Net
Cash Flows
Cumulative
Net Cash
Flows
0 (17,000) $ (17,000) $
1 4,000 (13,000)
2 3,500 (9,500)
3 3,500 (6,000)
4 3,500 (2,500)
5 3,500 1,000
6 3,500 4,500
7 3,000 7,500
8 3,000 10,500
4.7
TexCo recovers the
$17,000 purchase price
between years 4
and 5, about 4.7
years for the
payback period.
Payback Period
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Ignores the
time value
of money.
Ignores cash
flows after
the payback
period.
Payback Period
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Consider two projects, each with a five-year
life and each costing $6,000.
Project One Project Two
Net Cash Net Cash
Year Inflows Inflows
1 2,000 $ 1,000 $
2 2,000 1,000
3 2,000 1,000
4 2,000 1,000
5 2,000 1,000,000
Would you invest in Project One just because
it has a shorter payback period?
Payback Period
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The accounting rate of return focuses on
accounting income instead of cash flows.



Accounting Rate of Return
Accounting Operating income
rate of return Average investment
=
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Reconsider the $17,000 investment being
considered by TexCo. The annual operating
income is $2,000. Compute the
accounting rate of return.
Accounting Rate of Return
Accounting Operating income
rate of return Average investment
=
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Reconsider the $17,000 investment being
considered by TexCo. The annual operating
income is $2,000. Compute the
accounting rate of return.
Accounting Rate of Return
Cash flow 4,000 $
Depreciation 2,000
Operating income 2,000 $
Depreciation = ($17,000 - 1,000) 8 years
Accounting Operating income
rate of return Average investment
=
Beginning book value + Ending book value
2
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
16-67
Accounting Rate of Return
Accounting $2,000
rate of return $9,000
=
$17,000 + $1,000
2
Reconsider the $17,000 investment being
considered by TexCo. The annual operating
income is $2,000. Compute the
accounting rate of return.
= 22.2%
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
16-68
Depreciation may
be calculated
several ways.
Income may vary
from year to year.
Time value of
money is ignored.
So why
would I ever
want to use
this method
anyway?
Accounting Rate of Return
McGraw-Hill/Irwin
2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
16-69
End of Chapter 16