Session 7

Managerial Decision Making (Relevant Costs, Incremental Analysis)

Relevant Costs
 A relevant cost is a cost that is applicable to a particular decision that should have a bearing on which alternative a manager selects.  Relevant cost (incremental) approach is especially helpful when
Information is incomplete for detailed I/S Important impact factors need to be highlighted
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Identifying Relevant Costs

 Avoidable costs are relevant costs which can be eliminated (in whole or in part) as a result of choosing one alternative over another.  All costs are avoidable, except:
Sunk costs. Future costs that do not differ between the alternatives at hand.

 Fixed costs may or may not be avoidable

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Sunk Costs: Example

 Replacing an old machine with a new one?
Sales are $200,000 per year and fixed expenses other than depreciation are $70,000 per year.
New machine: List price Annual variable expenses Expected life in years Old machine: Original cost Remaining book value Disposal value now Annual variable expenses Remaining life in years
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$ 90,000 80,000 5 $ 72,000 60,000 15,000 100,000 5

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Sunk Costs: Financial Accounting

Profitability on accounting books
Remaining book value Disposal value Loss from disposal

 What would accounting profits suggest?

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Sunk Costs: Correct Analysis

Look at the comparative cost and revenue for the next 5 years.
Keep Old Machine Purchase New Machine

For Five Years Sales Variable expenses Other fixed expenses Depreciation - new Depreciation - old Disposal of old machine Total net income

Difference

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Sunk Costs: A Shortcut

We could prepare the analysis using only relevant costs:
Relevant Cost Analysis Savings in variable expenses provided by the new machine ($20,000 5 yrs.) Cost of the new machine Disposal value of old machine Net effect
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Future Costs That Do Not Differ are Irrelevant Costs

 Any future cost that does not differ between the alternatives in a decision situation is not a relevant cost so far as the decision is concerned.  Example: In choosing between machines 1 and 2, if the annual operating costs of both machines are the same, then operating costs are irrelevant.

45-701: Accounting for Decision Making and Control

Example: Adding/Dropping Segments

Segment Income Statement Digital Watches Sales Less: variable expenses Variable mfg. costs Variable shipping costs Commissions Contribution margin Less: fixed expenses General factory overhead Salary of line manager Depreciation of equipment Advertising - direct Rent - factory space General admin. expenses Net loss
45-701: Accounting for Decision Making and Control

$ $ 120,000 5,000 75,000 $ $ 60,000 90,000 50,000 100,000 70,000 30,000

500,000

200,000 300,000

400,000 $ (100,000)
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Example: Adding/Dropping Segments

 If the digital watch line is dropped, the fixed general factory overhead and general administrative expenses will be allocated to other product lines because they are not avoidable.  The equipment used to manufacture digital watches has no resale value or alternative use.  Should Lovell retain or drop the digital watch segment?
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Example: Adding/Dropping Segments Comparative Income Approach

Sales Less variable expenses: Mfg. expenses Freight out Commissions Total variable expenses Contribution margin Less fixed expenses: General factory overhead Salary of line manager Depreciation Advertising - direct Rent - factory space General admin. expenses Total fixed expenses Net loss Comparative Income Keep Digital Watches $ 500,000 120,000 5,000 75,000 200,000 300,000 60,000 90,000 50,000 100,000 70,000 30,000 400,000 $ (100,000)
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Drop Digital Watches

Difference

45-701: Accounting for Decision Making and Control

Example: Adding/Dropping Segments Contribution Margin Approach

Decision rule: Lovell should drop the digital watch segment only if its fixed cost savings exceed lost contribution margin.
Contribution Margin Solution Contribution margin lost if digital watches are dropped Less fixed costs that can be avoided Salary of the line manager Advertising - direct Rent - factory space Net disadvantage
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Example: The Make or Buy Decision

Essex manufactures part 457A that is currently used in one of its products. The unit cost to make this part is:
Direct materials Direct labor Variable overhead Depreciation of special equip. Supervisor's salary General factory overhead Total cost per unit
45-701: Accounting for Decision Making and Control

9 5 1 3 2 10 30
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Example: The Make or Buy Decision

 The special equipment used to manufacture part 457A has no resale value.  General factory overhead is allocated on the basis of direct labor hours.  The $30 total unit cost is based on 20,000 parts produced each year.  An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part. Should we accept the suppliers offer?
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Example: The Make or Buy Decision

Cost Per Unit Outside purchase price Direct materials Direct labor Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost $ 9 5 1 3 2 10 $ 30 Cost of 20,000 Units Buy Make

The depreciation and overhead are not avoidable and therefore irrelevant. If the product is dropped, they will simply be reallocated to other products.
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Joint Products
Joint Costs
Common Production Process Oil Separate Processing Final Sale

Joint Input

Gasoline

Final Sale

Chemicals

Separate Processing

Final Sale

Split-Off Point
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Joint Products

Separate Product Costs

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Joint Cost Allocation

 Joint costs are really common costs incurred to simultaneously produce a variety of end products.  Joint costs are often allocated to end products for inventory valuation or cost-plus contract or other reasons (see cost allocation of session 5).  The allocation base commonly used is relative sales value of each product at split-off point.

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Irrelevance of Joint Cost allocation: Sell or Process Further

 Joint product costs are not relevant in decisions regarding what to do with a product after the split-off point forward. At the split-off point joint product costs have already been incurred and cannot be avoided.  Caution: avoid allocation of joint costs for decisionmaking purposes  As a general rule,
It is always profitable to continue processing a joint product after the split-off point so long as the incremental revenue exceeds the incremental processing costs.
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Example: Sell or Process Further

 Sawmill, Inc. cuts logs from which unfinished lumber and sawdust are the immediate joint products.  Unfinished lumber is sold as is or processed further into finished lumber.  Sawdust can also be sold as is to gardening wholesalers or processed further into presto-logs.
Sales value at the split-o point Sales value after further pro essing Allo ated joint produ t costs Cost of further processing
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Per Log Lu ber Sawdu $ 140 $ 40 70 50 176 24 50 20

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Example: Sell or Process Further

Analysis of Sell or Process Further Per Log
Lumber Sawdust

Sales value after further processing Sales value at the split-off point Incremental revenue Cost of further processing Profit (loss) from further processing

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Utilization of Scarce Resources

 (End of Ch. 4, p. 126)  Firms 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 of the scarce resources.
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Example: Utilization of Scarce Resources

Ensign Company produces two products and selected data is shown below:
Products 1 Selling price per unit Less: variable expenses per unit ontribution margin per unit urrent demand per week (units) ontribution margin ratio Processing time required on machine A1 per unit $ 60 36 $ 24 2,000 40% 1.00 min. $ 2 50 35 $ 15 2,200 30% 0.50 min.

Machine A1 capacity is 2,400 minutes per week. Machine A1 is being used at 100% of its capacity and is the scarce resource.
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Example: Utilization of Scarce Resources

Contribution margin per unit of the scarce resource
Products Contribution margin per unit Time required to produce one unit Contribution margin per minute

How the recommended plan works?

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Managing Constraints
 Produce only what can be sold.  At the bottleneck itself,
Improve the process Add overtime or another shift Hire new workers or acquire more machines Subcontract production

 Eliminate waste.  Streamline production process.

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