Chapter 5 Decision Making: Relevant Costs and Benefits

DIFFERENTIAL COSTS AND REVENUES Bill is currently employed as a lifeguard, but he has been offered a job in an auto service center in the same town. The differential revenues and costs between the two jobs are listed below: Life- guard Auto Service Center Differential costs and revenues Monthly salary$1,200$1,500$300 Monthly expenses: Commuting Meals150 0 Apartment rent450 0 Uniform rental050 Union dues 10 0 (10) Total monthly expenses Net monthly income$ 560$ 760$200

Identifying Relevant Costs

Analysis of Special Decisions – Make or Buy Let’s take a look at a decision faced by many businesses. W We need a particular component for our manufacturing process. Do you think we should make or buy this particular item?

Make or Buy Han Products manufactures 30,000 units of part S-6 each year for use on its production line. At this level of activity, the cost per unit for part S-6 is as follows: Direct materials $3.60 Direct labor Variable manufacturing overhead 2.40 Fixed manufacturing overhead 9.00 Total cost per part $25.00

Make or Buy (continued) An outside supplier has offered to sell 30,000 units of part S-6 each year to Han Products for $21 per part. If Han Products accepts this offer, the facilities now being used to manufacture part S-6 could be rented to another company at an annual rental of $80,000. However, Han Products has determined that two-thirds of the fixed manufacturing overhead being applied to part S-6 would continue even if part S-6 were purchased from the outside supplier. Prepare computations showing how much profits will increase or decrease if the outside supplier’s offer is accepted.

Analysis of Special Pricing Decisions Let’s take a look at another decision faced by many businesses: W Another firm has offered to pay us $10 for a product that normally sells for $25. Do you think we should accept this special order?

Accept/Reject Special Orders Polaski Company manufactures and sells a single product called a Ret. Operating at capacity, the company can produce and sell 30,000 Rets per year. Costs associated with this level of production and sales are given below: The Rets normally sell for $50 each. Fixed manufacturing overhead is constant at $270,000 per year within the range of 25,000 through 30,000 Rets per year. UnitTotal Direct materials$15$450,000 Direct labor8 240,000 Variable manufacturing overhead3 90,000 Fixed manufacturing overhead9 270,000 Variable selling expense4 120,000 Fixed selling expense6 180,000 Total cost$45$1,350,000

Accept/Reject Special Orders (continued) Assume that due to a recession, Polaski Company expects to sell only 25,000 Rets through regular channels next year. A large retail chain has offered to purchase 5,000 Rets if Polaski is willing to accept a 16% discount off the regular price. There would be no sales commissions on this order; thus, variable selling expenses would be slashed by 75%. However, Polaski Company would have to purchase a special machine to engrave the retail chain’s name on the 5,000 units. This machine would cost $10,000. Polaski Company has no assurance that the retail chain will purchase additional units in the future. Determine the impact on profits next year if this special order is accepted.

Accept/Reject Special Orders (continued) Refer to the original data. Assume again that Polaski Company expects to sell only 25,000 Rets through regular channels next year. The U.S. Army would like to make a one-time-only purchase of 5,000 Rets. The Army would pay a fixed fee of $1.80 per Ret, and it would reimburse Polaski Company for all costs of production (variable and fixed) associated with the units. Because the army would pick up the Rets with its own trucks, there would be no variable selling expenses associated with this order. If Polaski Company accepts the order, by how much will profits increase or decrease for the year?

Accept/Reject Special Orders (continued) Assume the same situation as that described in the previous slide, except that the company expects to sell 30,000 Rets through the regular channels next year. Thus, accepting the U.S. Army’s order would require giving up regular sales of 5,000 Rets. If the Army’s order is accepted, by how much will profits increase or decrease from what they would be if the 5,000 Rets were sold through regular channels?

Utilizing a Constrained Resource Let’s take a look at another decision faced by many businesses: W One of our machines is a constraint in the operation. What products should we produce on this machine?

Scarce Resource Constraint A company has two products: a plain cellular phone and a fancier cellular phone with many special features: PlainFancy PhonePhone Selling price $ 80 $ 120 Variable costs Contribution margin $ 16 $ 36 Contribution-margin ratio 20% 30%

Scarce Resource Constraint Which product is more profitable? On which should the firm spend its resources? It depends. If sales are restricted by demand for only a limited number of phones, fancy phones are more profitable.

Scarce Resource Constraint Suppose annual demand for phones of both types is more than the company can produce in the next year. Only 10,000 hours of capacity are available If in one hour plant workers can make either three plain phones or one fancy phone, which phone is more profitable?

Scarce Resource Constraint PlainFancyPhone 1. Units per hour Contribution margin per unit $ 16 $ 36 Contribution margin per hour Total contribution for 10,000 hours

Constrained Resources Westford Company produces three products, A110, B382, and C657. Unit data for the three products follows: Product A110B382C657 Selling Price$84$56$70 Variable Costs Direct materials24159 Labor and other costs Quantity of Bistide per unit8 lb.5 lb.3 lb.

Constrained Resources (continued) All three products use the same direct material, Bistide. The demand for the products far exceeds the direct materials available to produce the products. Bistide costs $3 per pound and a maximum of 5,000 pounds is available each month. Westford must produce a minimum of 200 units of each product. How many units of product A110, B832, and C657 should Westford produce?

Analysis of Equipment Replacement Decisions Let’s take a look at another decision faced by many businesses: W Should we replace a machine with a newer and more efficient one?

Equipment Replacement Decision A manager at White Co. wants to replace an old machine with a new, more efficient machine:

Equipment Replacement Decision White’s sales are $200,000 per year Fixed expenses, other than depreciation, are $70,000 per year Should the manager purchase the new machine?

Another Equipment Replacement Decision Toledo Company is considering replacing a metal-cutting machine with a newer model. The new machine is more efficient than the old machine, but it has a shorter life. Revenues from aircraft parts ($1.1 million per year) will be unaffected by the replacement decision. Here’s the data on the existing (old) machine and the replacement (new) machine:

Equipment Replacement Decision (cont.) Old MachineNew Machine Original Cost$1,000,000$600,000 Useful Life5 years2 years Current age3 years0 years Remaining useful life2 years Accumulated Depreciation$600,000Not acquired yet Book Value$400,000Not acquired yet Current disposal value (in cash)$40,000Not acquired yet Terminal disposal value (in cash 2 years from now) $0 Annual operating costs (maintenance, energy, repairs, coolants, and so on) $800,000$460,000

Equipment Replacement Decision (cont.) Toledo Corporation uses straight-line depreciation. To focus on relevance, we ignore time value of money and income taxes. Should Toledo replace its old machine?