Chapter 6 Relevant Information and Decision- Making: Production Decisions

Objective 1 Define Opportunity Cost and Use it to Analyze the Income Effects of a Given Alternative

Opportunity, Outlays and Differential Costs Opportunity cost is the maximum available contribution to profit forgone (or passed up ) by using limited resources for a particular purpose. This definition indicates that opportunity cost is not the usual outlay cost recorded in accounting. Opportunity cost is the contribution of the best alternative that is excluded .

Outlay cost Differential cost A cost that requires a cash disbursement. Outlay cost is the typical cost recorded by account . Differential cost Or incremental cost is the difference in total cost between two alternatives .

Opportunity Cost The contribution to profit of best of the rejected alternatives. ( contribution of the best alternative is excluded from consideration.) An example The salary forgone by a person who quits a job to start a business.

Alternatives under Consideration Difference Open a new business Remain as employee 140,000 200,000 60,000 Revenues 120,000 - Outlay costs 20,000 80,000 Income effect per year The opportunity cost of the new business is 60,000 the forgone annual salary. Alternative chosen: New business 200,000 Revenues Expenses: 120,000 Outlay costs 60,000 Opportunity cost of employee salary 180,000 20,000 Income effect per year

The first solution (tabulation) does not mention opportunity cost because the economic impacts are individually measured for each of the alternatives. Neither alternative has been excluded from consideration The second mention opportunity cost (60.000 salary, impact of the best excluded alternative) as a cost of the chosen alternative The failure to recognize opportunity cost in the second tabulation wile misstate the difference between alternatives.

If the first alternatives is chosen Alternative chosen: Remain as employee 60,000 Revenues Expenses: - Outlay costs 80,000 Opportunity cost of independent practice (20,000) Income effect per year

Objective 2 Analyze Given Data to Support a Decision to Make or Buy Certain Parts or Products

Make or Buy and Idle Facilities Companies often must decide whether to produce its own parts and subassemblies or buy them from an outside supplier. Sometimes quantitative factors dominate qualitative assessments of costs. Some manufactures always make parts because they want to control quality, others because they possess special know-how, usually skilled labor or rare raw materials needed for production. Alternatively, some companies always purchase parts to protect mutually advantageous long-run relationships with their suppliers.

What quantitative factors are relevant to the decision to make or buy ? A key Factor is whether there are idle facilities. The key to make-or-buy decisions is identifying the additional costs for making ( or the costs avoided by buying ) a part or subcomponent. The relevant costs to this decision include the additional variable costs, and the fixed costs that will be eliminated if the parts are bought instead of made

Buy Make Per unit Total 10 200,000 Purchase cost : 1 20,000 Direct material 4 80,000 Direct labor 2 40,000 Variable factory overhead Fixed factory overhead that can be avoided by not making (supervisor’s salary) 8 160,000 Total relevant costs Difference in favor of making

Make or Buy : Use of Facilities The choice in make- or- buy decisions is not only whether to make or buy, it is how best to use available facilities. Suppose the released facilities can be used in some other manufacturing activity ( to produce a contribution to profits of, say, L.E. 55.000) or can be rented out (say, for L.E. 35.000).

The alternatives are: Make the parts. Buy the part and leave facilities idle. Buy and rent out facilities. Buy and use facilities for other products. Buy &use facilities for other product Buy &rent out facilities Buy & leave facilities idle Make - 35 Rent revenue 55 Contribution from other products (200) (160) Obtaining of parts (145) (165) Net relevant costs

Electrical and Mechanical Components Example Industrial Drills Plastic Housing Electrical and Mechanical Components 10,000,000 Revenue100,000 unit,@ L.E. 100 Variable costs : 4,900,000 500,000 4,400,000 Direct material 700,000 300,000 400,000 Direct labor 200,000 100,000 Variable factory overhead - Other variable costs 1,000,000 Sales commissions @ 10% of sales 7,000,000 6,000,000 Total variable costs 3,000,000 Contribution margin 2,300,000 1,900,000 Reparable fixed costs 80,000 320,000 Common fixed costs 2,700,000 480,000 2,220,000 Total fixed costs Operating income

Required During the year a prospective customer in an unrelated market offered L.E. 82.000 for 1,000 drills. The latter would be in addition to the 100,000 units sold. The regular sales commission rate would have been paid. The president rejected the order because " it was below cur costs of L.E. 97 per unit " What would operating income have been if the order had been accepted? 1 A supplier offered to manufacture the year's supply of 100,000 plastic housings for L.E. 13.50 each. What would be the effect on operating income if the Block Company purchased rather than made the housings? Assume that L.E.350,000 of the separable fixed costs assigned to housings would have been avoided if the housings were purchased. 2

3 The company could have purchased the housings for L.E. 13.50 each and used the vacated space for the manufacture of a deluxe version of its drill. Assume that 20,000 deluxe units could have been made ( and sold in addition to the 100,000 regular units) at a unit variable cost of L.E.90, exclusive of housings and exclusive of the 10% sales commission. The 20,000 extra plastic housings could also be purchased for L.E. 13.50 each. The sales price would have continued, because these costs related primarily to the manufacturing facilities used. What would operating income have been if Block had bought the housings and made and sold the deluxe units?

The costs of filling the special order follow: Solution The costs of filling the special order follow: 1 49,000 Direct material 7,000 Direct labor 3,000 Variable factory overhead 1,000 Other variable costs 8,200 Sales commissions @ 10% of sales × 82,000 68,200 Total variable costs 82,000 Selling price 13,800 Contribution margin Operating income would have been L.E.300.000 + L.E. 13.800 or L.E. 313.800, if the order had been accepted. In a sense, the decision to reject the offer implies that the Block Company is willing to invest L.E. 13.800 in immediate gains forgone (an opportunity cost ) in order to preserve the long – run selling- price structure.

Assuming that L.E. 350.000 of the fixed costs could have been avoided by not making the housings and that the other fixed costs would have been continued, the alternatives can be summarized as follows: 2 Buy Make 1,350,000 Purchase cost 1,000,000 Variable costs 350,000 Avoidable fixed costs Total relevant costs If the facilities used for plastic housings became idle, the Block Company would be indifferent as to whether to make or buy. Operating income would be unaffected.

The effect of purchasing the plastic housings and using the vacated facilities for manufacture of a deluxe version of its drill is: 3 2,600,000 Sales would increase by 20,000 units,@ L.E. 130 1,800,000 Variable costs exclusive of parts would increase by 20,000 units,@ L.E. 90 2.060,000 260,000 Plus: sales commission, 10% of L.E. 2, 600,000 540,000 Contribution margin on 20,000 units Housing: 120,000 rather than 100,000 would be Needed 1,620,000 Buy 120,000@ L.E. 13.50 1,000,000 Make 100,000 @ L.E. 10 (only the variable costs Are relevant) 620,000 Excess cost of outside purchase - Fixed costs, unchanged 80,000 Disadvantage of making deluxe units

Operating income would decline to L. E. 220,000 (L. E. 300,000 - L. E Operating income would decline to L.E. 220,000 (L.E.300,000 - L.E. 80,000). The deluxe un bring in a contribution margin of L.E. 540,000, but the additional costs of buying rather than making housings is L.E. 620,000, leading to a net disadvantage of L.E. 80,000.

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