McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Twenty Relevant Information for Special Decisions

20-2 Learning Objective 1 Identify the characteristics of relevant information.

20-3 Relevant Information Two primary characteristics distinguish relevant from useless information: Two primary characteristics distinguish relevant from useless information: 1.Relevant information differs among the alternatives under consideration. 2.Relevant information is future oriented. Two primary characteristics distinguish relevant from useless information: Two primary characteristics distinguish relevant from useless information: 1.Relevant information differs among the alternatives under consideration. 2.Relevant information is future oriented.

20-4 Relevant (Differential) Revenues Relevant revenues must (1) be future oriented and (2) differ from the alternatives under consideration. Since relevant revenues differ between the alternatives, they are sometimes called differential revenues.

20-5 Relevant (Avoidable) Costs Businesses seek to minimize costs. Managers avoid costs whenever possible. Relevant costs are frequently called avoidable costs. They are costs managers can eliminate by making specific choices.

20-6 Relevance – Other Issues Relevance is context-sensitive. A particular cost that is relevant in one context may be irrelevant in another. Relevance versus Accuracy. Information need not be exact to be relevant.

20-7 Learning Objective 2 Recognize sunk costs and explain why they are not relevant in decision making.

20-8 Sunk Cost A sunk cost has been incurred in a past transaction and cannot be changed; they are not relevant for making current decisions. Wish I hadn’t bought that stock. Cost me $25,000, and now it’s worth only $15,000. I really need a car but don’t have the cash! Just sell the stock and buy the car!

20-9 Sunk Cost A sunk cost has been incurred in a past transaction and cannot be changed; they are not relevant for making current decisions. I don’t want to take the loss! You’ve already taken the loss. The $25,000 is a sunk cost. Like I said, sell the stock and buy the car you need.

20-10 Learning Objective 3 Distinguish between unit-level, batch-level, product-level, and facility-level costs and understand how these costs affect decision making.

20-11 Cost Hierarchy Unit-level costs are incurred each time a company generates one unit of product. Batch-level costs are associated with producing a batch of products. Product-level costs are incurred to support a specific product or service. Facility-level costs are incurred to support the entire company.

20-12 Cost Avoidance & 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 if a product line is eliminated.

20-13 Relevance Is an Independent Concept Management at Better Bakery is debating whether to add a new product, either cakes or pies, to the company’s product line. Project costs are shown: Under either alternative a new production supervisor must be hired at a cost of $25,000 per year. Cakes are distributed under a nationally advertised label. Pies are marketed under the company’s own name and will require new advertising.

20-14 Relevance Is an Independent Concept Which costs are relevant? Fifty cents can be avoided by choosing cakes instead of pies. Labor costs do not differ. The supervisor’s salary is not relevant because it does not differ. The franchise fee can be avoided if the company makes pies and the advertising costs can be avoided if it makes cakes. Whether a cost is fixed or variable has no bearing on its relevance.

20-15 Learning Objective 4 Identify opportunity costs and explain why they are relevant in decision making.

20-16 Relevancy of Opportunity Costs The sacrifice represented by a lost opportunity is an opportunity cost. Opportunity costs that are (1) future oriented and (2) differ between the alternatives are relevant for decision making, but are extremely difficult to measure. Let’s look at an example.

20-17 Check Yourself Aqua, Inc. makes statues for use in fountains. On January 1, 2003, the company paid $13,500 for a mold to make a particular type of statue. The mold had an expected life of four years and a salvage value of $1,500. On January 1, 2005, the mold had a market value of $3,000, and a salvage value of $1,200. The expected useful life did not change. What is the relevant cost of using the mold during 2005? ($3,000 – $1,200) ÷ 2 years = $900 Of course, Aqua could avoid the cost by selling the mold for its market value of $3,000.

20-18 Learning Objective 5 Distinguish between quantitative and qualitative characteristics of decision making.

20-19 Quantitative vs. Qualitative Data Relevant information can have both quantitative and qualitative characteristics. Features such as company reputation, welfare of employees, and customer satisfaction Numbers or amounts used in decision making Both quantitative and qualitative data are relevant to decision making.

20-20 Learning Objective 6 Make appropriate special order decisions by analyzing relevant information.

20-21 Relevant Information and Special Decisions Occasionally, a company receives an offer to sell its product at a price significantly below its normal selling price. The company must make a special order decision to accept or reject the offer.

20-22 $ Cost per unit - $658,500 ÷ 2000 = $ Here is budgeted cost information for Premier, a company that produces printers. The company has enough capacity to produce additional printers, but is planning to produce to meet current demand.

20-23 Special Order Decision A foreign customer offers to purchase 200 printers at $250 per printer. This price is well below the unit cost of $ Should the company accept this one time order? If the order is accepted, income will increase by $11,800.

20-24 Special Order Decision If Premier can increase income by selling its printer for $250, can the company reduce its normal selling price to $250?

20-25 Learning Objective 7 Make appropriate outsourcing decisions by analyzing relevant information.

20-26 Outsourcing Decisions outsourcing Companies can sometimes purchase products needed in the manufacturing process for less than it would cost to make them. Buying goods and services from other companies rather than producing them internally is commonly called outsourcing. That test was so easy. Why is your score so low? I outsourced my homework!!

20-27 Outsourcing Decisions Let’s return to our Premier example. Recall that the unit cost per printer was $ A supplier offers to sell an unlimited number of printers to Premier for $240 each. Should Premier accept this outsourcing offer? Step 1 Determine the production costs Premier can avoid if it elects to outsource printer production. Cost per unit = $459,300 ÷ 2,000 = $229.65

20-28 Outsourcing Decisions Step 2 Compare the avoidable production costs with the cost of buying the product and select the lower-cost option. Premier should reject the outsourcing offer.

20-29 Growth and the Level of Production The decision to outsource would change if expected production increase from 2,000 to 3,000 units. Some avoidable costs are fixed relative to production, so cost per unit decreases as volume increases. If Premier outsources the 3,000 printers it will save $40,000 currently being spent on warehouse space. Cost per unit = $690,300 ÷ 3,000 = $ Management will still reject the offer, if growth is expected in the future. Growth must be factored into the outsourcing decision.

20-30 Qualitative Features A company that uses vertical integration controls the full range of activities from acquiring raw materials to distributing goods and services. An oil company, like Exxon, is a good example of vertical integration. Outsourcing reduces the level of vertical integration, passing some of a company’s control over its production to outside suppliers.

20-31 Learning Objective 8 Make appropriate segment elimination decisions by analyzing relevant information.

20-32 Segment Elimination Decisions Businesses are frequently organized into operating units known as segments. Segment reports can be prepared for products, services, departments, branches, centers, offices, or divisions. These reports normally show segment revenues and costs. Let’s look at a segment report for Premier Office Products that has divided its operations into three segments: (1) copiers, (2) computers, and (3) printers.

20-33 Should management eliminate the Copier segment?

20-34 Segment Elimination Decisions A three-part decision: 1.Determine the amount of relevant revenue that pertains to eliminating the segment. 2.Determine the amount of cost that can be avoided if the segment is eliminated. 3.If the relevant revenue is less than the avoidable cost, eliminate the segment. If not, continue to operate it.

20-35 Segment Elimination Decisions Step 1: If Premier eliminates the copier segment, it will lose the $550,000 of revenue currently produced. If the segment continues, the revenue will be earned. Since the revenue differs between the alternatives, it is relevant.

20-36 Segment Elimination Decisions Step 2: If Premier eliminates copiers, it will avoid the following costs:

20-37 Segment Elimination Decisions Step 2: If Premier eliminates copiers, its profits will decrease: The corporate-level facility-sustaining costs will not be eliminated, but will be allocated to the remaining segments.

20-38 Assuming we eliminate the copier segment and allocate the corporate-level costs to the remaining two divisions equally, the company’s income statement will look like this.

20-39 Qualitative Considerations 1.Employee lives will be disrupted. 2.Sales of different product lines are frequently interdependent. 3.What will happen to the space freed by the eliminated segment? 4.Volume changes can affect elimination decisions. 1.Employee lives will be disrupted. 2.Sales of different product lines are frequently interdependent. 3.What will happen to the space freed by the eliminated segment? 4.Volume changes can affect elimination decisions.

20-40 Relationships Between Avoidable Costs and Business Activity 1.Special order decisions affect unit-level and possibly batch-level costs. 2.Outsourcing can avoid many product-level as well as unit- and batch-level costs. 3.Segment elimination can avoid some of the facility- level costs. 1.Special order decisions affect unit-level and possibly batch-level costs. 2.Outsourcing can avoid many product-level as well as unit- and batch-level costs. 3.Segment elimination can avoid some of the facility- level costs. The more complex the decision level, the more opportunities there are to avoid costs.

20-41 Learning Objective 9 Make appropriate asset replacement decisions by analyzing relevant information.

20-42 Equipment Replacement Decision The equipment replacement decision should be based on profitability rather than physical deterioration. Consider the following:

20-43 Equipment Replacement Decision 1.The original cost, current book value, accumulated depreciation, and annual depreciation expense are measures of cost of the old machine relating to prior periods. They are irrelevant because they are sunk costs. 2.The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement decision. 3.The salvage value of the old machine reduces the opportunity cost. The opportunity cost of using the old machine for five more years is $12,000 ($14,000 – $2,000). 4.The $45,000 operating expenses of using the old machine can be avoided if it is replaced, so it is a relevant cost.

20-44 Equipment Replacement Decision 1.The cost of the new machine can be avoided by keeping the old machine, so it is a relevant cost. 2.The relevant cost of purchasing the new machine is $25,000 ($29,000 – $4,000). 3.The $22,500 of operating expenses can be avoided by keeping the old machine, so the operating expenses are relevant costs. Let’s summarize the relevant costs for the two machines.

20-45 Equipment Replacement Decision Our analysis shows that Premier should acquire the new machine. Over a five-year period the company will save a total of $9,500 ($57,000 – $47,500)

20-46 Learning Objective 10 Explain the conflict between short- and long-term profitability. (Appendix)

20-47 Short-Term vs. Long-Term Goals A decision maker under significant pressure to report higher profitability may be willing to sacrifice tomorrow’s profits to look better today. Misguided reward systems can encourage decision makers to focus on short-term profits. Upper-level management should establish policies and procedures that motivate subordinates to perform in ways that maximize the company’s long- term profitability.

20-48 Learning Objective 11 Make decisions about allocating scarce resources by analyzing relevant information. (Appendix)

20-49 Allocation of Scare Resources Factors that limit a business’s ability to satisfy the demand for its product are called constraints. A product’s contribution margin can be used to measure its profitability. Other things being equal, the product that produces the highest contribution margin per unit of scarce resource (constraint) is the more profitable product. The theory of constraints (TOC) is a management practice to increase profitability by managing bottlenecks or constrained resources.

20-50 End of Chapter Twenty