Relevant Information for Special Decisions Chapter 4

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-2 Relevant Information differs between the alternatives under consideration and is future oriented. Relevant Information differs between the alternatives under consideration and is future oriented. Sunk Cost has already been incurred in a past transaction, and cannot be avoided. Not a relevant cost. Sunk Cost has already been incurred in a past transaction, and cannot be avoided. Not a relevant cost.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-3 Relevant Revenues and Costs Relevant Revenues are expected future revenues that differ between the alternatives under consideration. Relevant Revenues are expected future revenues that differ between the alternatives under consideration. Relevant Costs are avoidable costs that can be eliminated by taking a specified course of action. Relevant Costs are avoidable costs that can be eliminated by taking a specified course of action.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-4 Cost Avoidance is Related to a Cost Hierarchy Unit-level Activities Batch-level Activities Product-level Activities Facility-level Activities Avoided by eliminating one unit of product. Avoided when a batch of work is eliminated. Avoided if a product line is eliminated. Some costs may be avoided when a product line is eliminated.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-5 Relevance is an Independent Concept The management of Better Bakery is trying to decide whether the production of cakes or pies would be more profitable.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-6 Relevance is an Independent Concept The cakes will be distributed under a nationally advertised label and requires a franchise fee. The pies will be sold under Better Bakery’s own name and additional advertising is necessary. For either alternative we will hire a production supervisor at a cost of $25,000. Which costs are relevant?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-7 Relevance is an Independent Concept We could avoid 50¢ of materials by choosing to make cakes instead of pies! So, this is a relevant cost. We could avoid 50¢ of materials by choosing to make cakes instead of pies! So, this is a relevant cost.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-8 Relevance is an Independent Concept Labour costs are the same under either alternative, so they are not relevant. The same for the supervisor’s salary. Labour costs are the same under either alternative, so they are not relevant. The same for the supervisor’s salary.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-9 Relevance is an Independent Concept We can avoid the franchise fee if we make pies! We can avoid the franchise fee if we make pies! I know. But, we can avoid the advertising costs if we make cakes. I know. But, we can avoid the advertising costs if we make cakes.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-10 Opportunity Costs are Relevant Opportunity Cost The sacrifice of a potential benefit associated with a lost opportunity. Opportunity Cost The sacrifice of a potential benefit associated with a lost opportunity. By attending college, you miss the opportunity to earn a salary by working full time.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-11 Quantitative Versus Qualitative Characteristics of Decision Making Quantatative Characteristics Numbers in decision making subject to mathematical manipulation, such as the dollar amounts of revenues and expenses. Quantatative Characteristics Numbers in decision making subject to mathematical manipulation, such as the dollar amounts of revenues and expenses. Qualatative Characteristics Nonquantifiable features, such as company reputation, welfare of employees, and customer satisfaction, that can be affected by certain decisions. Qualatative Characteristics Nonquantifiable features, such as company reputation, welfare of employees, and customer satisfaction, that can be affected by certain decisions.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-12 Relevant Information and Decision Making Five types of special decisions are frequently encountered in business practices:  Special order  Outsourcing  Segment elimination  Asset replacement  Scarce resource allocation

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-13 Special Order Decisions Stoerner Office Products manufactures copy machines, computers, and printers. The company expects to sell 2,000 printers next year, and will manufacture the printers in 10 batches of 200 printers per batch. The accountants at Stoerner provide us with the cost information on the next slide.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-14 Each printer cost $ $658,500 2,000

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-15 Special Order Decisions Each printer sells for $360. Stoerner receives a special order for 200 printers at a price of $250 each. The company has excess capacity and could manufacture the additional printers with no change in its other activities. Should Stoerner accept the order?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-16 Special Order Decisions Product-level and facility-level costs will be incurred even if the special order is rejected. Product-level and facility-level costs will be incurred even if the special order is rejected.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-17 Relevance and the Decision Context Look what would happen if Stoerner reduces its selling price to existing customers.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-18 Relevance and the Decision Context What do you think Stoerner should do?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-19 Outsourcing Decision It may be possible for a company to purchase a product or service at a price below what it would cost to make the product or provide the service. Let’s see how this works at Stoerner. Printer Supply of America

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-20 Outsourcing Decision A supplier has offered to sell an unlimited supply of printers to Stoerner at a price of $240 each. Recall that it currently cost Stoerner $ for each printer manufactured. Should Stoerner accept this proposal? Printer Supply of America

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-21 Outsourcing Decision These costs may be avoided by Stoerner if the printer is purchased from the supplier rather than manufactured. Relevant Unit Cost = $459,300 ÷ 2,000 = $229.65

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-22 Relevant Unit Cost = $459,300 ÷ 2,000 = $ Outsourcing Decision These costs may be avoided by Gates if the printer is purchased from the supplier rather than manufactured. Since the relevant cost of production is below the purchase price of the printers, the quantitative analysis suggests that Stoerner Gates should continue to make the printers. Since the relevant cost of production is below the purchase price of the printers, the quantitative analysis suggests that Stoerner Gates should continue to make the printers.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-23 Outsourcing Decision The accountant at Stoerner determined that if we stopped manufacturing printers, we could use the free space for warehousing finished goods inventory. The company could save $40,000 per year that it is currently spending to rent warehouse. Would this change your decision about outsourcing?

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-24 Outsourcing Decision Total relevant cost $ 459,300 Warehouse rent saved 40,000 New total relevant cost 499,300 Total printers outsourced 2,000 Cost per unit $ Total relevant cost $ 459,300 Warehouse rent saved 40,000 New total relevant cost 499,300 Total printers outsourced 2,000 Cost per unit $ Since the relevant unit cost is above the purchase price of $240.00, Stoerner should outsource the printers. Since the relevant unit cost is above the purchase price of $240.00, Stoerner should outsource the printers.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-25 Evaluating the Effect of Growth in the Level of Production If Stoerner sold 3,000 units per year, would outsourcing still be acceptable? Relevant unit cost = $690,300 ÷ 3,000 = $230.10

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-26 Qualitative Features The reliability of suppliers is a critically important consideration in the outsourcing decision. The reliability of suppliers is a critically important consideration in the outsourcing decision. Outsourcing usually involves employee displacement.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-27 Decisions to Eliminate Segments When accounting reports indicate that a particular segment is operating at a net loss, management must carefully consider the elimination of that segment. The copier segment of Stoerner has been reporting losses. The most recent financial information is shown on the next slide.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-28 Decisions to Eliminate Segments

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-29 Decisions to Eliminate Segments What happens to existing costs if Stoerner eliminates the copier division? Allocated corporate-level facility costs would be incurred even if Gates stopped making copiers. Allocated corporate-level facility costs would be incurred even if Gates stopped making copiers. Amortization is a sunk cost and can not be avoided. Amortization is a sunk cost and can not be avoided. Many segment-level, product-level, batch-level, and unit-level costs can be avoided if the copier division is eliminated. Many segment-level, product-level, batch-level, and unit-level costs can be avoided if the copier division is eliminated.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-30 Decisions to Eliminate Segments The copier segment contributes $62,000 per year to Stoerner profitability. If the segment is eliminated, profitability would decline by $62,000.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-31 Decisions to Eliminate Segments

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-32 Decisions to Eliminate Segments With the copier segment, total projected profit was $235,500. If the segment is eliminated, total projected profit will be only $173,500.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-33 Relevant Information for Special Decisions X = look for avoidable costs in this category.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-34 Equipment Replacement Decision Stoerner Office Products is considering replacing an older machine with a new, more efficient machine. The new machine will substantially reduce annual operating costs. Other information about the machines is shown on the next screen.

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-35 Equipment Replacement Decision $9,000 x 5 years $4,500 x 5 years

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-36 The original cost of the old machine, its book value, accumulated amortization, and annual amortization expense are all sunk costs and should be ignored. The original cost of the old machine, its book value, accumulated amortization, and annual amortization expense are all sunk costs and should be ignored. Equipment Replacement Decision The relevant costs for the two machines are...

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-37 Stoerner should acquire the new machine because it produces the lower relevant cost. Equipment Replacement Decision The relevant costs for the two machines are...

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada 4-38 End of Chapter 4