Kế toán, kiểm toán - Chapter 11: Relevant costs for decision making

Relevant Costs for Decision Making Chapter11Cost Concepts for Decision Making A relevant cost is a cost that differs between alternatives.12Identifying Relevant CostsCosts that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. Avoidable costs are relevant costs.Unavoidable costs are never relevant and include:Sunk costs.Future costs that do not differ between the alternatives.Identifying Relevant CostsSunk cost -- a cost that has already been incurred and that cannot be avoided regardless of what a manager decides to do.Identifying Relevant CostsWell, I’ve assembledall the costs associatedwith the alternativeswe are considering.Identifying Relevant CostsGreat! The first thing we need to do is eliminate all the sunk costs.Quick Check  In a decision of whether to buy a new car and trade-in your old car or just keep your old car, which of the following are sunk costs?a. The cost of licensing the new car.b. The cost of licensing your old car next year if you keep it.c. The amount you paid for your old car.d. The amount you paid to repair your old car last month in case you wanted to sell it.Quick Check  In a decision of whether to buy a new car and trade-in your old car or just keep your old car, which of the following are sunk costs?a. The cost of licensing the new car.b. The cost of licensing your old car next year if you keep it.c. The amount you paid for your old car.d. The amount you paid to repair your old car last month in case you wanted to sell it.Both of these costs have already been incurred and no decision now or in the future can change that fact.Identifying Relevant CostsNow that we have eliminated thesunk costs, we need to eliminatethe future costs that don’t differbetween alternatives.Quick Check  In a decision of whether to buy a new car and trade-in your old car or just keep your old car, which of the following are future costs that don’t differ between the alternatives?a. Monthly parking fees.b. Auto insurance.c. Theater tickets.d. Driver’s license renewal fee.Quick Check  In a decision of whether to buy a new car and trade-in your old car or just keep your old car, which of the following are future costs that don’t differ between the alternatives?a. Monthly parking fees.b. Auto insurance.c. Theater tickets.d. Driver’s license renewal fee.Auto insurance premiums usually depend on the car you drive. All of the other costs should be the same whether you drive your old car or your new car.Identifying Relevant CostsThe decision will beeasier now. All wehave left are theavoidable costs.Note Do not underestimate the importance and power of the relevant cost idea.Most costs (and benefits) do not differ between alternatives. This allows you to focus on the few things that matter.This principle also helps avoid mistakes.Sunk Costs are not Relevant CostsLet’s look at the White Companyexample.Sunk Costs are not Relevant CostsA manager at White Co. wants to replace an old machine with a new, more efficient machine.Sunk Costs are not Relevant CostsWhite’s sales are $200,000 per year.Fixed expenses, other than depreciation, are $70,000 per year. Should the manager purchase the new machine?Incorrect AnalysisThe manager recommends that the company not purchase the new machine since disposal of the old machine would result in a loss:Correct AnalysisLook at the comparative cost and revenue for the next five years.$200,000 per year × 5 years$100,000 per year × 5 yearsCorrect Analysis$70,000 per year × 5 yearsLook at the comparative cost and revenue for the next five years.Correct AnalysisThe remaining bookvalue of the old machine.Look at the comparative cost and revenue for the next five years.Correct Analysis$80,000 per year × 5 yearsLook at the comparative cost and revenue for the next five years.Correct AnalysisLook at the comparative cost and revenue for the next five years.The total cost will be depreciatedover the five year period.Correct AnalysisLook at the comparative cost and revenue for the next five years.The remaining book value of the oldmachine is a sunk cost and is notrelevant to the decision.Correct AnalysisLook at the comparative cost and revenue for the next five years.Would you recommend purchasing the new machine?Relevant Cost AnalysisLet’s look at amore efficientway to analyzethis decision.Relevant Cost AnalysisJust focus on the costs that differ between alternatives.Relevant Cost Analysis$100,000 - $80,000 = $20,000 variable cost savingsRelevant Cost AnalysisAdding/Dropping SegmentsOne of the most important decisions managers make is whether to add or drop a business segment such as a product or a store.Let’s see how relevant costs should be used in this decision.Adding/Dropping SegmentsDue to the declining popularity of digital watches, Lovell Company’s digital watch line has not reported a profit for several years. An income statement for last year is shown on the next screen.Adding/Dropping SegmentsAdding/Dropping SegmentsInvestigation has revealed that total fixed general factory overhead and general administrative expenses would not be affected if the digital watch line is dropped. The fixed general factory overhead and general administrative expenses assigned to this product would be reallocated to other product lines.Adding/Dropping SegmentsThe equipment used to manufacturedigital watches has no resalevalue or alternative use.Should Lovell retain or dropthe digital watch segment?A Contribution Margin ApproachDECISION RULELovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings exceed the lost contribution margin.Let’s look at this solution.A Contribution Margin ApproachComparative Income ApproachThe Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment.Let’s look at this second approach.If the digital watch line is dropped, the company gives up its contribution margin. On the other hand, the general factory overhead would be the same. So this cost really isn’t relevant. But we wouldn’t need a manager for the product line anymore. If the digital watch line is dropped, the net book value of the equipment would be written off. The depreciation that would have been taken will flow through the income statement as a loss instead. Beware of Allocated Fixed CostsWhy should we keep the digital watch segment when it’s showing a loss?Beware of Allocated Fixed CostsThe answer lies in the way we allocate common fixed costs to our products.Beware of Allocated Fixed CostsOur allocations can make a segment look less profitable than it really is.The Make or Buy DecisionA decision concerning whether an item should be produced internally or purchased from an outside supplier is called a “make or buy” decision.Let’s look at the Essex Company example.The Make or Buy DecisionEssex manufactures part 4A that is currently used in one of its products.The cost per unit of this part is:The Make or Buy DecisionThe special equipment used to manufacture part 4A has no resale value.The total amount of general factory overhead, which is allocated on the basis of direct labor hours, would be unaffected by this decision.The $30 total cost per unit 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 supplier’s offer?The Make or Buy Decision20,000 × $9 per unit = $180,000The Make or Buy DecisionThe special equipment has no resale value and is a sunk cost.The Make or Buy DecisionNot avoidable and is irrelevant. If the product is dropped, it will be reallocated to other products.The Make or Buy DecisionShould we make or buy part 4A?The Make or Buy DecisionDECISION RULEIn deciding whether to accept the outside supplier’s offer, Essex isolated the relevant costs of making the part by eliminating:The sunk costs.The future costs that will not differ between making or buying the parts.The Matter of Opportunity CostThe benefits that are foregone as a result of pursuing some course of action.Opportunity costs are not actual dollar outlays and are not recorded in the accounts of an organization.Quick Check  Which of the following are opportunity costs of attending the university?a. Tuition.b. Books.c. Lost wages.d. Not enough time for other interests.Quick Check  Which of the following are opportunity costs of attending the university?a. Tuition.b. Books.c. Lost wages.d. Not enough time for other interests.Opportunity costs do not have to involve money.Special OrdersJet, Inc. makes a single product whose normal selling price is $20 per unit.A foreign distributor offers to purchase 3,000 units for $10 per unit. This is a one-time order that would not affect the company’s regular business.Annual capacity is 10,000 units, but Jet, Inc. is currently producing and selling only 5,000 units.Should Jet accept the offer?Special Orders$8 variable costSpecial OrdersIf Jet accepts the offer, net income will increase by $6,000.Note: This answer assumes that fixed costs are unaffected by the order and that variable marketing costs must be incurred on the special order.Quick Check  Northern Optical ordinarily sells the X-lens for $50. The variable production cost is $10, the fixed production cost is $18 per unit, and the variable selling cost is $1. A customer has requested a special order for 10,000 units of the X-lens to be imprinted with the customer’s logo. This special order would not involve any selling costs, but Northern Optical would have to purchase an imprinting machine for $50,000. (see the next page) Quick Check  What is the rock bottom minimum price below which Northern Optical should not go in its negotiations with the customer? In other words, below what price would Northern Optical actually be losing money on the sale? There is ample idle capacity to fulfill the order.a. $50b. $10c. $15d. $29Quick Check  What is the rock bottom minimum price below which Northern Optical should not go in its negotiations with the customer? In other words, below what price would Northern Optical actually be losing money on the sale? There is ample idle capacity to fulfill the order.a. $50b. $10c. $15d. $29Variable production cost $100,000Additional fixed cost 50,000Total relevant cost $150,000Number of units 10,000Average cost per unit $15Utilization of a Constrained ResourceFirms often face the problem of deciding how to best utilize a constrained resource.Usually fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin.Let’s look at the Ensign Company example.Utilization of a Constrained ResourceEnsign Company produces two products and selected data is shown below:Utilization of a Constrained ResourceMachine A1 is the constrained resource and is being used at 100% of its capacity. There is excess capacity on all other machines. Machine A1 has a capacity of 2,400 minutes per week.Should Ensign focus its efforts on Product 1 or 2?Quick Check  How many units of each product can be processed through Machine A1 in one minute? Product 1 Product 2a. 1 unit 0.5 unitb. 1 unit 2 unitsc. 2 units 1 unitd. 2 units 0.5 unitQuick Check  How many units of each product can be processed through Machine A1 in one minute? Product 1 Product 2a. 1 unit 0.5 unitb. 1 unit 2 unitsc. 2 units 1 unitd. 2 units 0.5 unitI was just checking to make sure you are awake.Quick Check  What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2?a. Product 1b. Product 2c. They both would generate the same profitd. Cannot be determinedQuick Check  What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2?a. Product 1b. Product 2c. They both would generate the same profitd. Cannot be determinedWith one minute of machine A1, we could make 1 unit of Product 1, with a contribution margin of $24, or 2 units of Product 2, each with a contribution margin of $15. 2 × $15 > $24Utilization of a Constrained ResourceThe key is the contribution margin per unit of the constrained resource.Product 2 should be emphasized. Provides more valuable use of the constrained resource machine A1, yielding a contribution margin of $30 per minute as opposed to $24 for Product 1.Utilization of a Constrained ResourceIf there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use remaining capacity to make Product 1.Utilization of a Constrained ResourceLet’s see how this plan would work.Utilization of a Constrained ResourceLet’s see how this plan would work.Utilization of a Constrained ResourceLet’s see how this plan would work.Utilization of a Constrained ResourceAccording to the plan, we will produce 2,200 units of Product 2 and 1,300 of Product 1. Our contribution margin looks like this.The total contribution margin for Ensign is $64,200.Quick Check  Colonial Heritage makes reproduction colonial furniture from select hardwoods. The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand?a. Yesb. NoQuick Check  Colonial Heritage makes reproduction colonial furniture from select hardwoods. The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand?a. Yesb. No2  600 + 10  100 = 2,200 > 2,000Quick Check  The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits?a. 500 chairs and 100 tablesb. 600 chairs and 80 tablesc. 500 chairs and 80 tablesd. 600 chairs and 100 tablesQuick Check  The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits?a. 500 chairs and 100 tablesb. 600 chairs and 80 tablesc. 500 chairs and 80 tablesd. 600 chairs and 100 tablesQuick Check  As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?a. $40 per board footb. $25 per board footc. $20 per board footd. ZeroQuick Check  As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?a. $40 per board footb. $25 per board footc. $20 per board footd. ZeroThe additional wood would be used to make tables. In this use, each board foot of additional wood will allow the company to earn an additional $20 of contribution margin and profit.Quick Check  As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume there is unlimited demand for chairs. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?a. $40 per board footb. $25 per board footc. $20 per board footd. ZeroQuick Check  As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume there is unlimited demand for chairs. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?a. $40 per board footb. $25 per board footc. $20 per board footd. ZeroSince there is unlimited demand for chairs and chairs are a more valuable use of wood than tables, all of the additional wood would presumably be used to produce chairs. In this use, each board foot of additional wood will allow the company to earn an additional $25 of contribution margin and profit.Managing ConstraintsFinding ways to process more units through a resource bottleneckProduce only what can be sold.Streamline production process.Eliminate waste. At the bottleneck itself: •Improve the process • Add overtime or another shift • Hire new workers or acquired more machines • Subcontract productionEnd of Chapter 11