Relevant Costs and Benefits for Decision Making Module 17 Relevant Costs and Benefits for Decision Making © Cambridge Business Publishers, 2018

Distinguish between relevant and irrelevant revenues and costs. 1 Distinguish between relevant and irrelevant revenues and costs. © Cambridge Business Publishers, 2018

Relevant and Irrelevant Costs Future costs that differ among competing decision alternatives Future costs that DO NOT differ among competing decision alternatives Primary focus is profit maximization Additional factors that must be considered Effects on long-run profit Nonquantitative factors Such as legal, ethical, social © Cambridge Business Publishers, 2018

Future Revenues and Outlay Costs Relevant if they differ between alternatives Outlay costs Outlay costs require future expenditures of cash or other resources Relevant outlay costs Outlay costs that differ between decisions Irrelevant outlay costs Outlay costs that do not differ between decisions © Cambridge Business Publishers, 2018

Sunk Costs Result from past decisions that cannot be changed Sunk costs are NEVER relevant Sunk costs in decisions to replace a machine Cost of old machine Book value of old machine Can cause ethical dilemmas Managers often avoid disposing of old assets Disposing may create a loss on the income statement, making the manager’s performance look bad © Cambridge Business Publishers, 2018

Disposal and Salvage Values Disposal value Amount of cash an old asset can be sold for at the time the new asset is purchased Relevant cash inflow Obtained only if the replacement alternative is accepted Salvage value Amount of cash an asset will bring at the end of its useful life if held to that time © Cambridge Business Publishers, 2018

Opportunity Costs Any benefit forgone as a result of rejecting one alternative in favor of another Always relevant when making decisions among competing alternatives © Cambridge Business Publishers, 2018

Summary of Relevant and Irrelevant Costs Remember that the deciding factor in whether or not a cost is relevant is if the cost differs among alternatives. Only relevant costs are used in decision making. © Cambridge Business Publishers, 2018

2 Analyze relevant costs and indicate how they differ under alternative decision scenarios. © Cambridge Business Publishers, 2018

Relevant and Irrelevant Costs Example Trekker Tires manufacturers lawn mower tires. It produces and sells 10,000 tires annually at a selling price of $20 each. Management is evaluating the desirability of replacing the old assembly machine with a new machine. Data concerning the two machines: Old Machine Proposed Machine Cost $90,000 $80,000 Estimated useful life 6 years 4 years © Cambridge Business Publishers, 2018

Relevant and Irrelevant Costs Example Old Machine Proposed Machine Unit level: Direct materials $3.00 per unit Conversion $5.00 per unit $3.50 per unit Selling and distribution $1.00 per unit Batch level: Inspection and adjustment $500 per batch $400 per batch Batch size 1,000 Direct labor and variable manufacturing overhead required to convert raw materials into finished goods. The old machine is two years old with a current disposal value of $35,000. The proposed machine has a zero salvage value. © Cambridge Business Publishers, 2018

Relevant and Irrelevant Costs Example Old Machine Proposed Machine Unit level: Direct materials $3.00 per unit Conversion $5.00 per unit $3.50 per unit Selling and distribution $1.00 per unit Batch level: Inspection and adjustment $500 per batch $400 per batch Batch size 1,000 Difference in conversion costs Disposal value of old machine Difference in batch costs Difference in depreciation Direct material costs Selling and distribution costs Cost of old machine Selling price of tires © Cambridge Business Publishers, 2018

Differential Analysis An approach to the analysis of relevant costs that focuses on costs that differ between alternative actions Preferred over an aggregate analysis when determining which of two alternatives is most profitable Benefits Focuses on only items that differ Contains fewer items, making it easier and quicker to prepare Helps simplify complex situations © Cambridge Business Publishers, 2018

Apply differential analysis to evaluate changes in profit plans. 3 Apply differential analysis to evaluate changes in profit plans. © Cambridge Business Publishers, 2018

Changes in Profit Plans Example KonnectCo manufactures flash drives and sells them for €20 (euros). Management is considering 3 possible alternatives: Proposed Change Expected Effect on Units Sold Alternative #1 Increase advertising by €1,000 Sales increase by 300 units Alternative #2 Increase unit selling price by €1 Sales decrease by 300 units Alternative #3 Decrease unit selling price by €1 Sales increase by 500 units, with direct labor for the last 200 units increasing by €1 each due to overtime © Cambridge Business Publishers, 2018

Changes in Profit Plans Example Current costs to produce flash drives are: Variable Costs per Unit Direct materials €3 Direct labor 4 Manufacturing overhead 2 Selling and administrative 1 Fixed Costs per Month Manufacturing overhead €20,000 Selling and administrative 8,000 Average monthly production and sales is 4,000 units. © Cambridge Business Publishers, 2018

Changes in Profit Plans Example Alternative #1 Increase advertising by €1,000, with sales increasing by 300 units Unit contribution margin = €20 – (€3 + €4 + €2 + €1) = €10 Differential Analysis Profit increase from increased sales (300 units × €10) €3,000. Profit decrease from increased advertising (1,000) Increase in monthly profit €2,000. © Cambridge Business Publishers, 2018

Changes in Profit Plans Example Alternative #2 Increase selling by €1, with sales decreasing by 300 units Unit contribution margin = €20 – (€3 + €4 + €2 + €1) = €10 Differential Analysis Profit decrease from reduced sales (300 units × €10) €(3,000) Profit increase from increased selling price (3,700 units × €1) 3,700. Increase in monthly profit € 700. © Cambridge Business Publishers, 2018

Changes in Profit Plans Example Alternative #3 Decrease selling by €1, with sales increasing by 500 units, causing the last 200 units to incur overtime on direct labor costing €1 per unit more Unit contribution margin = €20 – (€3 + €4 + €2 + €1) = €10 Differential Analysis Profit increase from additional sales 500 units × (€19 – (€3 + €4 + €2 + €1)) €4,500. Profit decrease from decreased selling price (4,000 units × €1) (4,000) Profit decrease from overtime on 200 units (200 units × €1) (200) Increase in monthly profit € 300. © Cambridge Business Publishers, 2018

Changes in Profit Plans Example Alternatives #1 Increase monthly profit € 2,000 #2 Increase monthly profit € 700 #3 Increase monthly profit € 300 The best option is Alternative #1 because it results in the largest increase in profit. © Cambridge Business Publishers, 2018

4 Apply differential analysis to evaluate whether to accept a special order. © Cambridge Business Publishers, 2018

Special Orders Occurs when a customer wants to buy merchandise or obtain services on a “one time” basis at a price less than prices charged to other customers Usually involves a proposed purchase of a large volume of units What is relevant? Sales revenue Variable production costs Additional costs to be incurred © Cambridge Business Publishers, 2018

Variable Costs per Unit Special Order Example A customer offers to place a special, one-time order for 800 units at a reduced price of €16 per unit. KonnectCo has production capacity of 5,000 units and normally produces 4,200. KonnectCo will save 25% of its variable sales and administrative costs as a result. Should KonnectCo accept the order? Variable Costs per Unit Direct materials €3 Direct labor 4 Manufacturing overhead 2 Selling and administrative 1 Fixed Costs per Month Manufacturing overhead €20,000 Selling and administrative 8,000 KonnectCo’s Costs © Cambridge Business Publishers, 2018

Differential Analysis Special Order Example Differential Analysis Increase in revenues (800 units × €16) €12,800. Increase in costs Direct materials (800 × €3) €2,400 Direct labor (800 × €4) 3,200 Manufacturing overhead (800 × €2) 1,600 Selling and administrative (800 × €1 × 75%) 600 (7,800) Increase in profits € 5,000. KonnectCo should accept the order since its profits will increase by €5,000. The fixed portion of the selling and administrative costs remain at €8,000 no matter what level of activity. The special cost savings are for variable costs. © Cambridge Business Publishers, 2018

Concerns with Special Orders Time span concerns Future year cost increases should be considered in multiyear special orders Variable nature of long-term fixed costs In the long-run, all costs, fixed and variable, should be considered relevant Because they are subject to change over time Possible solutions Include a cost escalation clause in multiyear agreements Use full costs regardless of cost behavior patterns to approximate long-run variable costs © Cambridge Business Publishers, 2018

Multiyear Special Order Example What if the customer wanted KonnectCo to sign a multiyear contract to provide 800 units per month at €16 each? Full cost based on capacity Direct materials €3.00 Direct labor 4.00 Variable manufacturing overhead 2.00 Variable selling and administrative 0.75 Fixed manufacturing overhead (€20,000 / 5,000) Fixed selling and administrative (€8,000 / 5,000) 1.60 Average full cost per unit €15.35 KonnectCo should consider accepting a multiyear order based on full costs because €16 exceeds the full cost. © Cambridge Business Publishers, 2018

Special Order with Opportunity Costs Example What if KonnectCo were operating at capacity, its regular customers pay €20 per flash drive, and the special order customer wants to buy 800 units per month at €16 each? Lost sales to regular customers (units) 800. Regular unit contribution margin [€20 – (€3 + €4 + €2 + €1)] € 10. Opportunity cost of accepting the special order (8,000) Increase in profit if special order accepted [€16 – (€3 + €4 + €2 + €.75)] 5,000. Net decrease in profit is special order accepted (€3,000) KonnectCo’s profits would decrease by €3,000 if the special order is accepted if operating at capacity. © Cambridge Business Publishers, 2018

Qualitative Considerations of Special Orders Impact on regular customers Potential long-term benefits from the special order customer Trying to establish a customer relationship Legal factors Does the buyer compete with regular customers? © Cambridge Business Publishers, 2015

Apply differential analysis to evaluate outsourcing decisions. 5 Apply differential analysis to evaluate outsourcing decisions. © Cambridge Business Publishers, 2018

Outsourcing Outsourcing is the procurement of services, products, components from an external source. Possible reasons for outsourcing include: © Cambridge Business Publishers, 2018

Variable Costs per Unit Outsourcing Example Variable Costs per Unit Direct materials €3 Direct labor 4 Manufacturing overhead 2 Selling and administrative 1 Fixed Costs per Month Manufacturing overhead €20,000 Selling and administrative 8,000 KonnectCo’s Costs A manufacturer has offered to supply KonnectCo with all the flash drives it needs for one year at a cost of €9 each. If accepted, KonnectCo could eliminate production supervisor salaries that currently cost €1,000 per month. Normal production is 4,200 units each month. Should KonnectCo outsource? © Cambridge Business Publishers, 2018

Outsourcing Example There are no relevant revenues in outsourcing decisions. Cost to buy (€9 × 4,200 × 12 months) €453,600 Cost to make: Direct materials (€3 × 4,200 × 12) €151,200 Direct labor (€4 × 4,200 × 12) 201,600 Variable manufacturing overhead (€2 × 4,200 × 12) 100,800 Fixed manufacturing overhead (€1,000 × 12) 12,000 Total €465,600 Advantage of buying € 12,000 KonnectCo should consider outsourcing as profits will be higher by €12,000. © Cambridge Business Publishers, 2018

KonnectCo should consider outsourcing to increase profits by €27,000. Outsourcing Example If the space currently used to manufacture can be rented for €15,000 per year, what should KonnectCo do? Cost to buy (€9 × 4,200 × 12 months) €453,600 Cost to make: Direct materials (€3 × 4,200 × 12) € 151,200 Direct labor (€4 × 4,200 × 12) 201,600 Variable manufacturing overhead (€2 × 4,200 × 12) 100,800 Fixed manufacturing overhead (€1,000 × 12) 12,000 Opportunity cost of lost rental income if manufactured 15,000 . Total € 480,600 Advantage of buying € 27,000 KonnectCo should consider outsourcing to increase profits by €27,000. © Cambridge Business Publishers, 2018

6 Apply differential analysis to evaluate whether to sell or further process a product. © Cambridge Business Publishers, 2018

Sell or Process Further Decisions Key issue is to determine a product’s most advantageous selling point for products salable at various stages of completion Decision is whether To sell the product ‘as is’ Process the product further to sell for a higher selling price Two types of decisions Single products Joint products © Cambridge Business Publishers, 2018

Sell or Process Further Decision Example Stack’Em manufactures assembled, ready-to-paint book shelves for $18 each and sells them for $30 each. Painting the shelves would increase the total cost of a shelf to $23, but Stack’Em could then sell them for $38 each. What should Stack’Em do? Increase in revenues: Revenue per shelf if painted $38 Revenue per shelf if sold without paint 30 $ 8. Additional costs of painting ($23 – $18) (5) Advantage of painting for each shelf $ 3. Stack’Em should paint the shelves as profit increases by $3 per shelf. © Cambridge Business Publishers, 2018

Joint Product Cost Decisions What are joint products? Two or more products simultaneously produced by a single process from a common set of inputs Split-off point The point in the process where the joint product becomes separately identifiable Joint costs Costs incurred prior to the split-off point Are sunk costs and never relevant to joint product decisions or to process further decisions © Cambridge Business Publishers, 2018

7 Allocate limited resources for purposes of maximizing short-run profit. © Cambridge Business Publishers, 2018

Use of Limited Resources Managers should decide how to best use limited resources to accomplish organizational goals. Sometimes results in a product mix decision, i.e., which product should be produced with the limited resource? Examples of limited resources Limited capacity Limited labor hours due to lack of skilled labor Limited materials due to supply limitations Limited machine hours © Cambridge Business Publishers, 2018

Use of Limited Resources Single Constraint—Example Wilson Sports produces two models of baseball bats using white ash wood. Due to weather problems, wood supply is limited and Wilson is able to obtain only 24,000 board feet of white ash. Which bat should Wilson produce given the following information? Deluxe Bats Basic Bats Unit selling price $75 $54 Unit variable costs 34 25 Unit contribution margin $41 $29 Number of board feet of wood needed per bat 3.40 2.20 © Cambridge Business Publishers, 2018

Use of Limited Resources Single Constraint—Example Determine the contribution margin per board foot for each product. Deluxe Bats Basic Bats Unit contribution margin $41 $29 Number of board feet of wood needed per bat 3.40 2.20 Contribution margin per board foot: $41 / 3.40 = $12.06 $29 / 2.20 = $13.18 Deluxe bats generate $12.06 of profit for every board foot of white ash wood used, while basic bats generate $13.18. Therefore, basic bats should be produced. © Cambridge Business Publishers, 2018

Use of Limited Resources Multiple Constraint—Example Assume that Wilson Sports must produce at least 2,000 of each model to remain competitive. With the same material constraint of 24,000 board feet of white ash, how much will total contribution margin be when profit is maximized under the constraint? Deluxe: Contribution per board foot: $41/3.40 = $12.06 Basic: Contribution per board foot: $29/2.20 = $13.18 Produce more basic bats since they generate more contribution to profit per board foot than do the deluxe bats. © Cambridge Business Publishers, 2018

Use of Limited Resources Multiple Constraint—Example Subtract the board foot to be used for the minimum units of the least profitable product from available wood: Available board feet 24,000. Feet to be used for minimum deluxe bats (3.4 × 2,000) (6,800) Remaining feet to be used for basic bats 17,200. Determine the number of basic bats to be produced with the remaining board feet: Number of basic bats to be produced (17,200 / 2.20) = 7,818 Contribution margin generated: Contribution margin from deluxe bats ($41 × 2,000) $ 82,000 Contribution margin from basic bats ($29 × 7,818) 226,722 Total contribution margin $308,722 © Cambridge Business Publishers, 2018

A bottleneck is a constraining resource. Theory of Constraints States that Every process has a bottleneck, and Production cannot take place faster than it is processed through the bottleneck Goal is to maximize throughput in a constrained environment Throughput is sales revenue minus direct materials cost A bottleneck is a constraining resource. © Cambridge Business Publishers, 2018

Management’s Role in Bottlenecks Management should… Identify the bottlenecks Schedule production to maximize the efficient use of the bottleneck resource Schedule production to avoid a buildup of inventory Work to eliminate bottlenecks © Cambridge Business Publishers, 2018

Theory of Constraints To support the theory of constraints, performance reports should: Measure the utilization of bottleneck resources Measure factory throughput Not encourage the full utilization of non-bottleneck resources Discourage the buildup of excess inventory © Cambridge Business Publishers, 2018