1 CHAPTER M6 Making Decisions Using Relevant Information © 2007 Pearson Custom Publishing

2 Learning Objective 1: Identify the characteristics of a relevant cost. © 2007 Pearson Custom Publishing

3 Relevant Costing Internal decision makers are faced with tough decisions on a regular basis. When faced with a financial decision, managers are often overwhelmed by a mountain of information. Internal decision makers are faced with tough decisions on a regular basis. When faced with a financial decision, managers are often overwhelmed by a mountain of information. Relevant costing is the process of determining which pieces of information are relevant to the decision at hand. Relevant costing is the process of determining which pieces of information are relevant to the decision at hand. © 2007 Pearson Custom Publishing

4 Relevant Costs Costs can be accumulated for any imaginable reason. Relevant costs are those costs (and revenues) that need to be considered because they have an impact on a particular decision. Costs can be accumulated for any imaginable reason. Relevant costs are those costs (and revenues) that need to be considered because they have an impact on a particular decision. A factor that is relevant to one manager may not be relevant to the next. A factor that is relevant to one decision may not be relevant to the next. A factor that is relevant to one manager may not be relevant to the next. A factor that is relevant to one decision may not be relevant to the next. © 2007 Pearson Custom Publishing

5 Determining Relevant Costs To be relevant to a management decision, information must possess BOTH of these characteristics: To be relevant to a management decision, information must possess BOTH of these characteristics: it must be a future cost or revenue, and it must be a future cost or revenue, and it must differ between decision alternatives. it must differ between decision alternatives. Reasoned decision makers use only relevant information when making an economic decision. Reasoned decision makers use only relevant information when making an economic decision. © 2007 Pearson Custom Publishing

6 Learning Objective 2: Explain why sunk costs and costs that do not differ between alternatives are irrelevant costs. © 2007 Pearson Custom Publishing

7 Sunk Cost A sunk cost is a past cost that cannot be changed by current or future actions. A sunk cost is a past cost that cannot be changed by current or future actions. Examples of sunk costs: Examples of sunk costs: Equipment, land, or buildings purchased in the past Equipment, land, or buildings purchased in the past Equipment leased on a long-term lease Equipment leased on a long-term lease New vehicle purchased and used New vehicle purchased and used One-year old computer equipment One-year old computer equipment © 2007 Pearson Custom Publishing

8 Irrelevant Information We should identify irrelevant information and NOT use it in our analysis. Irrelevant information possesses either of the following characteristics: We should identify irrelevant information and NOT use it in our analysis. Irrelevant information possesses either of the following characteristics: it is a sunk cost or revenue, or it is a sunk cost or revenue, or it does not differ between alternatives. it does not differ between alternatives. A manager should filter out all irrelevant information before making a decision. A manager should filter out all irrelevant information before making a decision. © 2007 Pearson Custom Publishing

9 Learning Objective 3: Describe the qualitative factors that should be considered when making a business decision. © 2007 Pearson Custom Publishing

10 Quantitative or Qualitative Factors? Quantitative factors can be expressed as a number. Qualitative factors cannot be expressed numerically and must be described in words. Quantitative factors can be expressed as a number. Qualitative factors cannot be expressed numerically and must be described in words. Most management decisions require the consideration of both quantitative and qualitative factors. Most management decisions require the consideration of both quantitative and qualitative factors. © 2007 Pearson Custom Publishing

11 Quantitative or Qualitative Factors? Consider that management wants to purchase a new copier. Consider that management wants to purchase a new copier. Quantitative factors include: Quantitative factors include: Cost of the machine Cost of the machine Cost of machine maintenance Cost of machine maintenance Cost per copy of supplies Cost per copy of supplies Qualitative factors include: Qualitative factors include: Ease of operation Ease of operation Quality of copies made Quality of copies made Change in environment for users (noise, heat, etc.) Change in environment for users (noise, heat, etc.) © 2007 Pearson Custom Publishing

12 Learning Objective 4: Use accounting information and determine the relevant cost of various decisions. © 2007 Pearson Custom Publishing

13 Relevant Cost Decision Making When making a relevant cost decision, follow these steps in the process: When making a relevant cost decision, follow these steps in the process: Gather all costs associated with the decision. Gather all costs associated with the decision. Determine the relevant cost of each alternative. Determine the relevant cost of each alternative. Compare relevant costs and select an alternative. Compare relevant costs and select an alternative. © 2007 Pearson Custom Publishing

14 Equipment Replacement Managers are often faced with the decision to replace equipment or other long-term assets. This is actually a complicated decision with many uncontrollable factors, such as the rate of technological change. Managers are often faced with the decision to replace equipment or other long-term assets. This is actually a complicated decision with many uncontrollable factors, such as the rate of technological change. We will look at the basics of the replacement decision from a relevant cost perspective. We will look at the basics of the replacement decision from a relevant cost perspective. © 2007 Pearson Custom Publishing

15 Associated Costs We need to gather all relevant costs related to the equipment replacement decision. Any differential costs to be incurred in the future would be relevant. Possible examples include start-up costs, operating costs, and shutdown costs. We need to gather all relevant costs related to the equipment replacement decision. Any differential costs to be incurred in the future would be relevant. Possible examples include start-up costs, operating costs, and shutdown costs. Irrelevant costs will include the original and current book values of the old equipment, and all depreciation charges. Irrelevant costs will include the original and current book values of the old equipment, and all depreciation charges. © 2007 Pearson Custom Publishing

16 Replacement Example Company AYZ is considering the replacement of an old computer system with a new one. One qualitative factor to consider is the fact that the new computer will allow them to do various new computing tasks not possible with the old computer. Company AYZ is considering the replacement of an old computer system with a new one. One qualitative factor to consider is the fact that the new computer will allow them to do various new computing tasks not possible with the old computer. Let’s review the quantitative information. Let’s review the quantitative information. © 2007 Pearson Custom Publishing

17 Quantitative Cost Summary © 2007 Pearson Custom Publishing

18 Determine Relevant Costs of Keeping Old Computer Cost to purchase: irrelevant (sunk) Cost to purchase: irrelevant (sunk) Annual depreciation: irrelevant (repeat item) Annual depreciation: irrelevant (repeat item) Total depreciation: irrelevant (repeat item) Total depreciation: irrelevant (repeat item) Annual labor cost: irrelevant (no difference) Annual labor cost: irrelevant (no difference) Maintenance cost: relevant (differential) Maintenance cost: relevant (differential) Residual value: relevant (differential) Residual value: relevant (differential) Current sales value: relevant (future inflow) Current sales value: relevant (future inflow) © 2007 Pearson Custom Publishing

19 Determine Relevant Costs of Buying New Computer Cost to purchase: relevant (future outlay) Cost to purchase: relevant (future outlay) Annual depreciation: irrelevant (repeat item) Annual depreciation: irrelevant (repeat item) Total depreciation: irrelevant (repeat item) Total depreciation: irrelevant (repeat item) Annual labor cost: irrelevant (no difference) Annual labor cost: irrelevant (no difference) Maintenance cost: relevant (differential) Maintenance cost: relevant (differential) Residual value: relevant (differential) Residual value: relevant (differential) NOTE: this analysis ignores the income tax implications of the replacement decision. NOTE: this analysis ignores the income tax implications of the replacement decision. © 2007 Pearson Custom Publishing

20 Relevant Cost Comparison © 2007 Pearson Custom Publishing

21 Cost to Replace Computer The relevant cost analysis indicates a $4,000 cost savings in favor of keeping the old computer system. This analysis is based on quantitative factors only. The relevant cost analysis indicates a $4,000 cost savings in favor of keeping the old computer system. This analysis is based on quantitative factors only. Keep in mind that the new computer will allow AYZ to do various new computer tasks. They will analyze these added benefits in light of the $4,000 cost. Keep in mind that the new computer will allow AYZ to do various new computer tasks. They will analyze these added benefits in light of the $4,000 cost. © 2007 Pearson Custom Publishing

22 Discussion Questions Consider a slightly different computer replacement decision. Would your analysis change if you had purchased the old computer one year ago instead of six years ago? Consider a slightly different computer replacement decision. Would your analysis change if you had purchased the old computer one year ago instead of six years ago? Would your analysis change if you bought the old computer one month ago? What about one week ago? Would your analysis change if you bought the old computer one month ago? What about one week ago? © 2007 Pearson Custom Publishing

23 Time Value of Money Whenever long-term cash flows are being considered, the time value of money should be factored into the analysis. We will consider this factor in the next chapter. Whenever long-term cash flows are being considered, the time value of money should be factored into the analysis. We will consider this factor in the next chapter. The time value of money recognizes that a dollar received or spent in the future is not equal to a dollar received or spent today. The time value of money recognizes that a dollar received or spent in the future is not equal to a dollar received or spent today. © 2007 Pearson Custom Publishing

24 Special Order Decisions A manufacturing company is sometimes presented with a special order. Such an order usually includes a discounted price for the items being ordered. A manufacturing company is sometimes presented with a special order. Such an order usually includes a discounted price for the items being ordered. The manufacturer must decide whether to accept or reject the special order. The manufacturer must decide whether to accept or reject the special order. © 2007 Pearson Custom Publishing

25 Special Order Factors to Consider Quantitative factors to consider include: Quantitative factors to consider include: relevant manufacturing costs of the items, relevant manufacturing costs of the items, relevant selling/distribution costs of the items, relevant selling/distribution costs of the items, selling price to be paid by the customer, and selling price to be paid by the customer, and impact (if any) on regular sales volume. impact (if any) on regular sales volume. Qualitative factors may include the effect on the workforce (avoid layoffs?), competitive considerations, and prospects of future deals. Qualitative factors may include the effect on the workforce (avoid layoffs?), competitive considerations, and prospects of future deals. © 2007 Pearson Custom Publishing

26 Sample Data - Without Special Order © 2007 Pearson Custom Publishing

27 Special Order Example Assume that the CBA Company has received a special order for 1,000 units at a price of $80 per unit. Accepting this special order will not have any impact on CBAs normal sales volume. Assume that the CBA Company has received a special order for 1,000 units at a price of $80 per unit. Accepting this special order will not have any impact on CBAs normal sales volume. At first glance, the order appears to be an unacceptable offer. The special price is below the normal cost per unit of $100. At first glance, the order appears to be an unacceptable offer. The special price is below the normal cost per unit of $100. © 2007 Pearson Custom Publishing

28 Associated Costs The first step is to gather all of the associated costs and other pieces of financial information. This information was already presented for the CBA Company. The first step is to gather all of the associated costs and other pieces of financial information. This information was already presented for the CBA Company. The second step is to determine which costs are relevant to the decision to accept the special order. The second step is to determine which costs are relevant to the decision to accept the special order. © 2007 Pearson Custom Publishing

29 Determine Relevant Costs To be relevant to this special order, a cost has to differ between the accept and reject alternatives. To be relevant to this special order, a cost has to differ between the accept and reject alternatives. Unless total fixed costs are going to increase with the increased production of the special order units, all fixed costs are irrelevant to this decision. Unless total fixed costs are going to increase with the increased production of the special order units, all fixed costs are irrelevant to this decision. © 2007 Pearson Custom Publishing

30 Determine Relevant Costs Unless stated otherwise, all variable costs will be relevant to accepting the order. Unless stated otherwise, all variable costs will be relevant to accepting the order. By definition, total variable costs increase as volume increases. Thus, there will be 1,000 additional units manufactured and sold during this period, with a proportionate increase in the amount of variable costs incurred. By definition, total variable costs increase as volume increases. Thus, there will be 1,000 additional units manufactured and sold during this period, with a proportionate increase in the amount of variable costs incurred. © 2007 Pearson Custom Publishing

31 Relevant Cost Comparison © 2007 Pearson Custom Publishing

32 Special Order Final Analysis Although the special order price is below the normal full cost per unit, the CBA Company can experience a $30,000 increase in operating profit this period by accepting the special order. Although the special order price is below the normal full cost per unit, the CBA Company can experience a $30,000 increase in operating profit this period by accepting the special order. In some special order situations, the variable selling costs might not be relevant if they will be avoided on the extra units. In some special order situations, the variable selling costs might not be relevant if they will be avoided on the extra units. © 2007 Pearson Custom Publishing

33 Discussion Questions Can you give an example of a situation where accepting a special order could have a negative impact on your regular sales volume? Can you give an example of a situation where accepting a special order could have a negative impact on your regular sales volume? Can you give an example of a situation where the variable selling costs would not be relevant to a special order decision? Can you give an example of a situation where the variable selling costs would not be relevant to a special order decision? © 2007 Pearson Custom Publishing

34 Make or Buy Decision Some companies purchase certain products or parts instead of manufacturing them. Each product or part represents a separate make or buy decision. Some companies purchase certain products or parts instead of manufacturing them. Each product or part represents a separate make or buy decision. When a company chooses to purchase a service, product, or part from an outside vendor, it is called outsourcing. When a company chooses to purchase a service, product, or part from an outside vendor, it is called outsourcing. © 2007 Pearson Custom Publishing

35 Associated Costs We first need to gather information about all related costs. This includes all costs to manufacture the item as well as the cost to purchase the item. We first need to gather information about all related costs. This includes all costs to manufacture the item as well as the cost to purchase the item. Other obvious considerations include control over the quality of the product, and availability of the item in the quantities needed on a timely basis. Other obvious considerations include control over the quality of the product, and availability of the item in the quantities needed on a timely basis. © 2007 Pearson Custom Publishing

36 Make or Buy Example The EFG Company currently manufactures all of the parts used in the production of remote control toy cars. The EFG Company currently manufactures all of the parts used in the production of remote control toy cars. They have been approached by another company that has offered to supply the remote control device at a cost of $5.50 per unit. Quality and availability of the controls is not an issue. They have been approached by another company that has offered to supply the remote control device at a cost of $5.50 per unit. Quality and availability of the controls is not an issue. © 2007 Pearson Custom Publishing

37 Make or Buy Example © 2007 Pearson Custom Publishing

38 Determine Relevant Costs Relevant costs for the “make” alternative include only those future, differential production costs. By definition, all future variable production costs will be relevant. Relevant costs for the “make” alternative include only those future, differential production costs. By definition, all future variable production costs will be relevant. Fixed production costs stay constant in total regardless of the amount of production activity. Therefore, the fixed overhead cost allocated to this unit is irrelevant. Fixed production costs stay constant in total regardless of the amount of production activity. Therefore, the fixed overhead cost allocated to this unit is irrelevant. © 2007 Pearson Custom Publishing

39 Determine Relevant Costs The relevant costs of the “buy” alternative are easy to determine. If the supplier charges $5.50 per unit, and if there are no “hidden” or additional charges, then that amount represents the only relevant cost to buy the controls. The relevant costs of the “buy” alternative are easy to determine. If the supplier charges $5.50 per unit, and if there are no “hidden” or additional charges, then that amount represents the only relevant cost to buy the controls. © 2007 Pearson Custom Publishing

40 Relevant Cost Comparison © 2007 Pearson Custom Publishing

41 Changes in Fixed Costs In some situations, there may be some fixed manufacturing costs that are relevant. In some situations, there may be some fixed manufacturing costs that are relevant. It is possible that there could be an increase in the total fixed overhead costs if a special order was accepted. It is possible that there could be an increase in the total fixed overhead costs if a special order was accepted. It is also possible that total fixed costs could decrease if we purchased rather than manufactured a particular item. It is also possible that total fixed costs could decrease if we purchased rather than manufactured a particular item. © 2007 Pearson Custom Publishing

42 Changes in Fixed Costs Let’s continue with the make or buy example and add one more fact. Assume that the EFG Company would experience a $20,000 reduction in their fixed overhead costs if they started to buy the remote controls from the outside vendor. Let’s continue with the make or buy example and add one more fact. Assume that the EFG Company would experience a $20,000 reduction in their fixed overhead costs if they started to buy the remote controls from the outside vendor. This amount of fixed cost is now relevant since it is a future differential cost. This amount of fixed cost is now relevant since it is a future differential cost. © 2007 Pearson Custom Publishing

43 Make or Buy Revisited © 2007 Pearson Custom Publishing

44 Learning Objective 5: Explain the effects of fixed costs and opportunity costs on outsourcing decisions. © 2007 Pearson Custom Publishing

45 Opportunity Costs An opportunity cost is something of value that is given up when one alternative is chosen over another. An opportunity cost is something of value that is given up when one alternative is chosen over another. There is usually an opportunity cost involved when faced with a make or buy decision. If we choose not to make an item, those productive resources can usually be put to a profitable alternative use. There is usually an opportunity cost involved when faced with a make or buy decision. If we choose not to make an item, those productive resources can usually be put to a profitable alternative use. © 2007 Pearson Custom Publishing

46 Opportunity Cost Example Assume that if the EFG Company purchases the remote controls from the outside vendor, they could use the released production capacity to make remote control boats. Assume that if the EFG Company purchases the remote controls from the outside vendor, they could use the released production capacity to make remote control boats. The boats would use the same remote control (which the vendor would supply), and should not cause a reduction in the sales of the remote control cars. The boats would use the same remote control (which the vendor would supply), and should not cause a reduction in the sales of the remote control cars. © 2007 Pearson Custom Publishing

47 Opportunity Cost Example Let’s return to the original make or buy decision, where there was no change in the fixed overhead costs. Let’s return to the original make or buy decision, where there was no change in the fixed overhead costs. Assume that the sales of the remote control boats would result in a contribution margin of $10 per boat. Estimated sales of remote control boats are 5,000 units per period. Assume that the sales of the remote control boats would result in a contribution margin of $10 per boat. Estimated sales of remote control boats are 5,000 units per period. © 2007 Pearson Custom Publishing

48 Opportunity Cost Example © 2007 Pearson Custom Publishing

49 Opportunity Cost Analysis The $50,000 opportunity cost is added to the relevant cost of the make decision. The $50,000 opportunity cost is added to the relevant cost of the make decision. If they make the controls, they are unable to make the boats and unable to realize the increased profits from the boat sales. If they make the controls, they are unable to make the boats and unable to realize the increased profits from the boat sales. Without the opportunity cost, the choice is to make the units. With the opportunity cost, the choice is to buy the units. Without the opportunity cost, the choice is to make the units. With the opportunity cost, the choice is to buy the units. © 2007 Pearson Custom Publishing

50 Discussion Questions Analyze your dinner plans for tonight as a make or buy decision. What are the relevant costs of making a hamburger meal at home versus the cost of buying a hamburger meal at a restaurant? Analyze your dinner plans for tonight as a make or buy decision. What are the relevant costs of making a hamburger meal at home versus the cost of buying a hamburger meal at a restaurant? What are some of the qualitative factors that you would consider in this decision? What are some of the qualitative factors that you would consider in this decision? © 2007 Pearson Custom Publishing

51 The End of Chapter M6 © 2007 Pearson Custom Publishing