CHAPTER 6 PowerPoint Author: LuAnn Bean, Ph.D., CPA, CIA, CFE Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6-2 Relevant 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: 1.Relevant information differs among the alternatives under consideration. 2.Relevant information is future oriented.

6-3 Sunk Cost A sunk cost has been incurred in a past transaction and cannot be changed. It is not relevant for making current decisions. I 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! 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. I don’t want to take the loss!

6-4 Opportunity Costs An opportunity cost is the sacrifice that is incurred in order to obtain an alternative opportunity. I think I am beginning to see what you mean. The opportunity cost of owning the stock is $15,000. That is the amount you could receive if you decide to sell.

6-5 A quantitative focus considers the cost, increase in profits, or other numerical aspects of the decision. Quantitative Versus Qualitative Characteristics Relevant information can have both quantitative and qualitative characteristics. A qualitative focus considers non-quantitative aspects such as the impact on people and attractiveness of the products. For example, suppose you are deciding which of two laptops to purchase. Computer A costs $300 more than Computer B. Both computers satisfy your technical requirements; however Computer A has a more attractive appearance Computer A Computer B

6-6 Differential Revenue and Avoidable Cost Relevant revenues must (1) be future oriented and (2) differ for the alternatives under consideration. Since relevant revenues differ between the alternatives, they are sometimes called differential revenues.

6-7 Relevant (Avoidable) Costs Unit-level Costs Batch-level Costs Product-level Costs Facility-level Costs 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 business segment is eliminated.

6-8 Segment Elimination Decisions A three step 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. A three step 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.

6-9 Segment Elimination Decisions Step 1: If Premier eliminates the copier segment, it will lose the $550,000 of revenue currently earned. If the segment continues, the revenue will be earned. Since the revenue differs between the alternatives, it is relevant.

6-10 Segment Elimination Decisions Step 2: If Premier eliminates copiers, it will avoid the following costs:

6-11 Segment Elimination Decisions Step 3: 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.

6-12 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.

6-13 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.

6-14 Equipment Replacement Decisions The equipment replacement decision should be based on profitability rather than physical deterioration. Consider the following:

6-15 Equipment Replacement Decisions – Quantitative Analysis 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. It is a relevant cost. 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. It is a relevant cost.

6-16 What are the relevant costs if Premier purchases and uses the new machine? 1.The cost of the new machine can be avoided by keeping the old machine. 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. The operating expenses are relevant costs. Let’s summarize the relevant costs for the two machines.

6-17 Equipment Replacement Decisions 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).

6-18 A decision maker under significant pressure to report higher profitability may be willing to sacrifice tomorrow’s profits to look better today. Here is an example: While the total cost at the end of the five-year period is $9,500 less if the equipment is replaced ($100,000 - $90,500), the total costs at the end of the first year are higher by $32,500 ($52,500 - $20,000) if the old machine is replaced.

6-19 Theory of Constraints  Many businesses use a management practice known as the theory of constraints (TOC) to increase profitability by managing bottlenecks or constrained resources.  TOC’s primary objective is to identify the bottlenecks restricting the operations of the business and then to open those bottlenecks through a practice known as relaxing the constraints.

6-20 End of Chapter 6