Horngren Ima16 Stppt06 GE

Copyright © 2014 Pearson Education 6-1
Chapter 6
Relevant Information for

Decision Making with a Focus
on Operational Decisions

Chapter 6 Learning Objectives
When you have finished studying this chapter,

you should be able to:
1.Use a differential analysis to examine income

effects across alternatives and show that an
opportunity-cost analysis yields identical results.
2. Decide whether to make or to buy certain parts

or products.
3. Choose whether to add or delete a product line

using relevant information.

Chapter 6 Learning Objectives
4. Compute the optimal product mix when

production is constrained by a scarce resource.
5. Decide whether to process a joint product

beyond the split-off point.
6. Decide whether to keep or replace equipment.
7. Identify irrelevant and misspecified costs.
8. Discuss how performance measures can affect

decision making.

Learning Opportunity, Outlay, and
Objective 1
Differential Costs and Analysis
Differential cost is the difference in

total cost between two alternatives.
Differential revenue is the difference in

total revenue between two alternatives.
A differential analysis is a decision process

that compares differential revenues and
costs of alternatives.

Opportunity, Outlay, and
Incremental costs are additional costs or

reduced benefits generated by the proposed
alternative.
Incremental benefits are the additional

revenues or reduced costs generated by the
proposed alternative.
Analyzing the differential costs between the

existing situation and a proposed alternative
is an incremental analysis.

An outlay cost requires a cash disbursement.
If there are many alternative uses of resources,

an incremental analysis can become
cumbersome. Opportunity costs may be a
viable option.
An opportunity cost is the maximum available

benefit forgone (or passed up) by using a
resource that a company already owns or that
it has already committed to purchase for a
particular purpose.
Nantucket Nectars has a machine for

which it paid $100,000 and it is sitting idle.
Nantucket Nectars has three alternatives:

1. Increase production of Peach juice
2. Sell the machine
3. Produce a new drink Papaya Mango

Introducing Papaya Mango entails two types

of costs, outlay costs and opportunity costs.
Outlay costs include costs for items

such as materials and labor.
Opportunity cost is the maximum available

benefit forgone (or passed up) by using
such a resource for a particular purpose
instead of the best alternative use.

Peach Juice Contribution margin is $60,000.

Sell machine for $50,000.
Produce Papaya Mango juice with

projected sales of $500,000.
Suppose Nantucket Nectars will have total sales over the

life cycle of Papaya Mango 100% Juice of $500,000. The
production and marketing costs (outlay costs), excluding
the cost of the machine, are $400,000. What is the net
financial benefit from producing the Papaya Mango?
Copyright © 2014 Pearson Education 6 - 10

Revenues $500,000
Costs:
Outlay costs 400,000
Financial benefit before opportunity costs $100,000
Opportunity cost of machine 60,000
Net financial benefit $ 40,000
Nantucket Nectars will gain $40,000 more financial

benefit using the machine to make Papaya Mango than
it would make using it for the next most profitable
alternative.

Learning
Objective 2 Make-or-Buy Decisions
Managers often must decide whether to

produce a product or service within the
firm or purchase it from an outside supplier.
Purchasing products or services from an

outside supplier is called outsourcing.
Managers apply relevant cost analysis to a

variety of outsourcing decisions.

Make-or-Buy Decisions
Nantucket Nectars Company’s

Cost of Making 12-ounce Bottles
Direct material $ 60,000 $.06

Direct labor 20,000 .02
Variable factory overhead 40,000 .04
Fixed factory overhead 80,000 .08
Total costs $200,000 $.20
Another manufacturer offers to sell Nantucket

Nectars the bottles for $.18. Should Nantucket
Nectars make or buy the bottles?

Make-or-Buy Example
Perhaps Nantucket Nectars will eliminate

$50,000 of fixed costs if the company buys the
bottles instead of making them. For example, the
company may be able to release a supervisor
with a $50,000 salary.
If the company buys the bottles, $50,000

of fixed overhead would be eliminated.
Should Nantucket make or buy the bottles?

Relevant Cost Comparison
*Note that unavoidable fixed costs of $80,000 – $50,000 = $30,000 are irrelevant.
Thus, the irrelevant costs per unit are $.08 – $.05 = $.03.

Make or Buy and the
Use of Facilities
Suppose Nantucket can use the released

facilities in other manufacturing activities
to produce a contribution to profits of
$55,000, or can rent them out for $25,000.
What are the alternatives?

Make or Buy and the
Use of Facilities
Buy and Buy and use

leave Buy and facilities
(amounts facilities rent out for other
in $000) Make idle facilities products
Rent revenue $ — $ — $ 25 $ —
Contribution from
other products — — — 55
Variable cost of bottles (170) (180) (180) (180)
Net relevant costs $(170) $(180) $(155) $(125)

Learning Deletion or Addition of Products,
Objective 3
Services, or Departments
Often, existing businesses will want to expand or

contract their operations to improve profitability.
Decisions to add or to drop products or whether

to add or to drop departments will use the
same analysis: examining all the relevant costs
and revenues.
Relevant information plays an important role in

decisions about adding or deleting products,
services, or departments.

Avoidable and Unavoidable Costs
Avoidable costs are costs that will

not continue if an ongoing
operation is changed or deleted.
Unavoidable costs are costs that

continue even if an operation is halted.
Common costs are costs of facilities and

services that are shared by users.

Department Store Example
Consider a discount department store

that has three major departments:
Groceries
General merchandise
Drugs

Departments
(amounts General
in $000) Groceries Mdse. Drugs Total
Sales $1,900 $1,000 $800 $100

Variable exp. 1,420 800 560 60
Contribution
margin $ 480 (25%) $ 200 (20%) $240 (30%) $ 40 (40%)
Fixed expenses:
Avoidable $ 265 $ 150 $100 $ 15
Unavoidable 180 60 100 20
Total fixed exp. $ 445 $ 210 $200 $ 35
Operating income$ 35 $ (10) $ 40 $ 5

Assume that the only alternatives to

be considered are dropping or continuing
the grocery department, which has
consistently shown an operating loss.
Assume further that the total assets invested

would be unaffected by the decision.
The vacated space would be idle and

the unavoidable costs would continue.

Store as a Whole
Total Effect of Total
(amounts Before Dropping After
Change Groceries Change
in $000)
Sales $1,900 $1,000 $900

Variable expenses 1,420 800 620
Contribution margin $ 480 $ 200 $280
Avoidable fixed expenses 265 150 115
Profit contribution to
common space and
other unavoidable costs $ 215 $ 50 $165
Unavoidable expenses 180 0 180
Operating income $ 35 $ 50 $ (15)

Assume that the store could use the space

made available by the dropping of groceries
to expand the general merchandise department.
This will increase sales by $50,000,

generate a 30% contribution margin,
and have avoidable fixed costs of $70,000.
$80,000 – $50,000 = $30,000

Store as a Whole
(amounts Total Expand Total
Before Drop General After
Change Groceries Merchandise Change
in $000)
Sales $1,900 $1,000 $500 $1,400

Variable expenses 1,420 800 350 970
Contribution margin $ 480 $ 200 $150 $ 430
Avoidable fixed expenses 265 150 70 185
Profit contribution to
common space and
other unavoidable costs$ 215 $ 50 $80 $245
Unavoidable expenses 180 0 0 180
Operating income $ 35 $ 50 $80 $ 65

Relevant costs are not always variable. The

key to decision making is not relying on a
hard and fast rule about what to include
and what to ignore.
You must analyze all pertinent costs and

revenues to determine what is and what is
not relevant in the specific context. In this
case, the relevant costs included the
avoidable fixed costs.

Nonfinancial information can influence

decisions to add or delete products or
departments, too.
When deciding to delete a product or to

close a plant, there are ethical
considerations.
How will the decision affect:

Employees? Customers? Community?

Learning
Objective 4 Optimal Use of Limited Resources
A limiting factor or scarce resource

restricts or constrains the production
or sale of a product or service.
Limiting factors include labor hours and

machine hours that limit production
(and hence sales) in manufacturing firms . . .
and square feet of floor space or cubic

meters of display space that limit sales
in department stores.

Optimal Use of Limited Resources
Nike produces the Air Court tennis shoe and

the Air Max running shoe. Assume that one
factory is the only facility that produces the
shoes, and Nike managers must decide how
many shoes of each type to produce.
Machine time is the measure of capacity in

this factory, and there is a maximum of 10,000
hours of machine time. The factory can
produce 10 pairs of Air Court shoes or 5 pairs
of Air Max shoes in 1 hour of machine time.

Which is more profitable?
If the limiting factor is demand, that is, pairs

of shoes, the more profitable product is Air Max.

Air Max is the product with the

higher contribution per unit.
The sale of a pair of Air Court

shoes adds $20 to profit.
The sale of a pair of Air Max

shoes adds $36 to profit.

Suppose that demand for either shoe

would exceed the plant’s capacity.
Now, capacity is the limiting factor.
Which is more profitable?
If the limiting factor is capacity,

the more profitable product is Air Court.

Air Court
Contribution margin per pair × 10,000 hours
= $2,000,000 contribution
Air Max:
Contribution margin per pair × 10,000 hours
= $1,800,000 contribution

In retail stores, the limiting factor is

often floor space. The focus is on products
taking up less space or on using
the space for shorter periods of time.
Retail stores seek faster inventory

turnover (the number of times
the average inventory is sold per year).

Faster inventory turnover makes

the same product a more profitable
use of space in a discount store.
Regular Discount
Department Department
Store Store
Retail Price $4.00 $3.50

Costs of merchandise and other variable costs 3.00 3.00
Contribution to profit per unit $1.00 (25%) $ .50 (14%)
Units sold per year 10,000 22,000
Total contribution to profit, assuming the
same space allotment in both stores $10,000 11,000

Learning
Objective 5 Joint Product Costs
Joint products have relatively

significant sales values.
They 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 Product Costs
Separable costs are any costs

beyond the split-off point.
Joint costs are the costs of manufacturing

joint products before the split-off point.
Examples of joint products include

chemicals, lumber, flour, and the
products of petroleum refining.

Joint Product Costs
Suppose Dow Chemical Company produces

two chemical products, X and Y, as
a result of a particular joint process.
The joint processing cost is $100,000.
Both products are sold to the petroleum

industry to be used as ingredients of gasoline.

Joint Product Costs

Illustration of Sell
or Process Further
Suppose the 500,000 liters of Y can be

processed further and sold to the
plastics industry as product YA.
The additional processing cost would

be $.08 per liter for manufacturing
and distribution, a total of $40,000.
The net sales price of YA would be

$.16 per liter, a total of $80,000.

Illustration of Sell
or Process Further
Sell at Process
Split-off Further and
as Y Sell as YA Difference
Revenues $30,000 $80,000 $50,000

Separable costs
beyond split-off
@ $.08 – 40,000 40,000
Income effects $30,000 $40,000 $10,000

Learning
Objective 6 Equipment Replacement
The book value of equipment is not

a relevant consideration in deciding
whether to replace the equipment.
Because it is a past, not a future cost.

Book Value of Old Equipment
Depreciation is the periodic allocation

of the cost of equipment.
Accumulated depreciation is the sum of all

depreciation charged to past periods.
The equipment’s book value (or net book value)

is the original cost less accumulated depreciation.

Book Value of Old Equipment
Suppose a $10,000 machine with a 10-year life

span has depreciation of $1,000 per year.
What is the book value at the end of 6 years?
Original cost $10,000

Accumulated depreciation (6 × $1,000) 6,000
Book value $ 4,000

Keep or Replace the Old Machine?

Relevance of Equipment Data
A sunk cost is a cost already incurred and is

irrelevant to the decision-making process.
Book value of old equipment

Disposal value of old equipment
Gain or loss on disposal
Cost of new equipment

Relevance of Equipment Data
The book value of old equipment is irrelevant

because it is a past (historical) cost. Therefore,
depreciation on old equipment is irrelevant.
The disposal value of old equipment is

relevant because it is an expected future
inflow that usually differs among alternatives.
The cost of new equipment is relevant

because it is an expected future outflow
that will differ among alternatives.

Gain or Loss on Disposal
This is the difference between

book value and disposal value.
It is a meaningless combination
of irrelevant (book value) and
relevant items (disposal value).
It is best to think of each separately.

Cost Comparison

Learning
Objective 7 Irrelevant or Misspecified Costs
The ability to recognize irrelevant costs

is important to decision makers.

Irrelevant or Misspecified Costs
Suppose General Dynamics

has 100 obsolete aircraft
parts in its inventory.
The original manufacturing cost

of these parts was $100,000.
General Dynamics can remachine the

parts for $30,000 and then sell them for
$50,000, or scrap them for $5,000.
Remachine Scrap Difference
Expected future revenue $ 50,000 $ 5,000 $45,000

Expected future costs 30,000 0 30,000
Relevant excess of
revenue over costs $ 20,000 $ 5,000 $15,000
Accumulated historical
inventory cost* 100,000 100,000 0
Net loss on project $(80,000) $ (95,000) $15,000
* Irrelevant because it is unaffected by the decision.

There are two major ways to go wrong

when using unit costs in decision making:
1. including irrelevant costs
2. comparing unit costs not computed

on the same volume basis

Assume that a new $100,000 machine with

a five-year life can produce 100,000 units
a year at a variable cost of $1 per unit,
as opposed to a variable cost per unit
of $1.50 with an old machine.
Is the new machine a worthwhile acquisition?

Old Machine New Machine
Units 100,000 100,000

Variable cost $150,000 $100,000
Straight-line depreciation 0 20,000
Total relevant costs $ 45,000 $120,000
Unit relevant costs $ 1.50 $ 1.20

It appears that the new machine

will reduce costs by $.30 per unit.
However, if the expected volume is only

30,000 units per year, the unit costs
change in favor of the old machine.

Old Machine New Machine
Units 30,000 30,000

Variable costs $45,000 $30,000
Straight-line depreciation 0 20,000
Total relevant costs $45,000 $50,000
Unit relevant costs $1.50 $1.6667

Learning Decision Making and
Objective 8
Performance Evaluation
To motivate managers to make the right choice,

the method used to evaluate performance
should be consistent with the decision model.
Consider the replacement decision

where replacing a machine has
a $2,500 advantage over keeping it.

Decision Making and Performance Evaluation
Year 1 Years 2, 3, and 4

Keep Replace Keep Replace
Cash operating
costs $5,000 $3,000 $5,000 $3,000
Depreciation 1,000 2,000 1,000 2,000
Loss on disposal
($4,000 – $2,500) 0 $1,500 0 0
Total charges
against revenue $6,000 $6,500 $6,000 $5,000

Decision Making and Performance Evaluation
Performance is often measured by

accounting income, consider the
accounting income in the first year
after replacement compared with
that in years 2, 3, and 4.
If the machine is kept rather than

replaced, first-year costs will be
$500 lower ($6,500 – $6,000), and
first-year income will be $500 higher.

All rights reserved. No part of this publication
may be reproduced, stored in a retrieval system,
or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording,
or otherwise, without the prior written permission
of the publisher. Printed in the United States of
America.

Horngren Ima16 Stppt06 GE

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Horngren Ima16 Stppt06 GE

Uploaded by

Copyright:

Available Formats

Copyright © 2014 Pearson Education 6-1

Relevant Information for

Copyright © 2014 Pearson Education 6-2

When you have finished studying this chapter,

1.Use a differential analysis to examine income

2. Decide whether to make or to buy certain parts

3. Choose whether to add or delete a product line

Copyright © 2014 Pearson Education 6-3

4. Compute the optimal product mix when

5. Decide whether to process a joint product

6. Decide whether to keep or replace equipment.

7. Identify irrelevant and misspecified costs.

8. Discuss how performance measures can affect

Copyright © 2014 Pearson Education 6-4

Differential cost is the difference in

Differential revenue is the difference in

A differential analysis is a decision process

Copyright © 2014 Pearson Education 6-5

Incremental costs are additional costs or

Incremental benefits are the additional

Analyzing the differential costs between the

Copyright © 2014 Pearson Education 6-6

An outlay cost requires a cash disbursement.

If there are many alternative uses of resources,

An opportunity cost is the maximum available

Nantucket Nectars has a machine for

Nantucket Nectars has three alternatives:

Copyright © 2014 Pearson Education 6-8

Introducing Papaya Mango entails two types

Outlay costs include costs for items

Opportunity cost is the maximum available

Copyright © 2014 Pearson Education 6-9

Peach Juice Contribution margin is $60,000.

Produce Papaya Mango juice with

Suppose Nantucket Nectars will have total sales over the

Copyright © 2014 Pearson Education 6 - 10

Nantucket Nectars will gain $40,000 more financial

Copyright © 2014 Pearson Education 6 - 11

Managers often must decide whether to

Purchasing products or services from an

Managers apply relevant cost analysis to a

Copyright © 2014 Pearson Education 6 - 12

Nantucket Nectars Company’s

Direct material $ 60,000 $.06

Another manufacturer offers to sell Nantucket

Copyright © 2014 Pearson Education 6 - 13

Perhaps Nantucket Nectars will eliminate

If the company buys the bottles, $50,000

Should Nantucket make or buy the bottles?

Copyright © 2014 Pearson Education 6 - 14

Copyright © 2014 Pearson Education 6 - 15

Suppose Nantucket can use the released

What are the alternatives?

Copyright © 2014 Pearson Education 6 - 16

Buy and Buy and use

Copyright © 2014 Pearson Education 6 - 17

Often, existing businesses will want to expand or

Decisions to add or to drop products or whether

Relevant information plays an important role in

Copyright © 2014 Pearson Education 6 - 18

Avoidable costs are costs that will

Unavoidable costs are costs that

Common costs are costs of facilities and

Copyright © 2014 Pearson Education 6 - 19