1. Relevant Costs and Strategic Analysis1 1

2. Relevant Cost Analysis
Relevant costs are costs to be incurred at some future time and that differ for each option available to the decision maker.

3. The Car Purchase Decision
Relevant Costs
The Car Purchase Decision

4. Relevant Costs Old machine cost $4,200 when purchased
Which costs are not relevant to the decision to keep the old machine or replace it with a new, more efficient one?
Old machine cost $4,200 when purchased
Old machine has a book value of $2,100
Purchase price of a new machine is $7,000
New machine is expected to last two years
New machine will have zero salvage value
Repairs to old machine would be $3,500 and would allow two more years of productivity
Power for either machine is expected to be $2.50
New machine will reduce labor costs by $0.50 per hour
Expected level of output per year: 1,000 units

5. Relevant Costs Old machine cost $4,200 when purchased
Which costs are not relevant to the decision to keep the old machine or replace it with a new, more efficient one?
Old machine cost $4,200 when purchased
Old machine has a book value of $2,100
Purchase price of a new machine is $7,000
New machine is expected to last two years
New machine will have zero salvage value
Repairs to old machine would be $3,500 and would allow two more years of productivity
Power for either machine is expected to be $2.50
New machine will reduce labor costs by $0.50 per hour
Expected level of output per year: 1,000 units
Not relevant because
of the zero salvage.

6. Relevant Costs Relevant because the two years relate to a
Which costs are not relevant to the decision to keep the old machine or replace it with a new, more efficient one?
Relevant because
the two years
relate to a
relevant item.
Old machine cost $4,200 when purchased
Old machine has a book value of $2,100
Purchase price of a new machine is $7,000
New machine is expected to last two years
New machine will have zero salvage value
Repairs to old machine would be $3,500 and would allow two more years of productivity
Power for either machine is expected to be $2.50
New machine will reduce labor costs by $0.50 per hour
Expected level of output per year: 1,000 units

7. Relevant Costs Old machine cost $4,200 when purchased
Which costs are not relevant to the decision to keep the old machine or replace it with a new, more efficient one?
Old machine cost $4,200 when purchased
Old machine has a book value of $2,100
Purchase price of a new machine is $7,000
New machine is expected to last two years
New machine will have zero salvage value
Repairs to old machine would be $3,500 and would allow two more years of productivity
Power for either machine is expected to be $2.50
New machine will reduce labor costs by $0.50 per hour
Expected level of output per year: 1,000 units
Relevant because the 1,000 unit output is related to labor costs and savings.

8. So, the relevant costs are . . .
Old machine cost $4,200 when purchased
Old machine has a book value of $2,100
Purchase price of a new machine is $7,000
New machine is expected to last two years
New machine will have zero salvage value
Repairs to old machine would be $3,500 and would allow two more years of productivity
Power for either machine is expected to be $2.50
New machine will reduce labor costs by $0.50 per hour
Expected level of output per year: 1,000 units

9. Should We Repair or Replace the Machine?

10. Determining Relevant Costs vs. Strategic Relevant Cost Analysis

11. The Decision-Making Process
First: Determine the Strategic Issues
Third: Analyze Relevant Costs
Second: Specify the Criteria and Identify the Alternative Actions
Identify and Collect Relevant Information
Predict Future Values of Relevant Costs & Revenues
Fourth: Select and Implement the Best Course of Action
Consider Strategic Issues
Fifth: Evaluate Performance

12. The Special Order Decision
Annual Fund Raiser Run

TTS, Inc. normally charges $9.00 per T-shirt, but Alpha Beta Gamma has offered to pay $6.50 for 1,000 T-shirts. What are the relevant costs in determining if the offer should be accepted?

13. The Special Order Decision
Relevant Costs
Not Relevant

14. The Special Order Decision
If TTS has excess capacity, the offer should be accepted because it will add $1,250 to net income (1,000 T-shirts × $1.25).

15. The Special Order Decision
If TTS is operating at full capacity, the offer should be rejected.
Contribution margin from
Alpha Beta Gamma order
($1.25 x 1,000 t-shirts) $1,250
Opportunity cost of lost sales
($ $5.25) x 1,000 (3,750
Contribution loss $(2,500 )

16. it from a supplier. Fixed overhead costs will not
Make, Lease, or Buy
Blue Tone is currently manufacturing the mouthpiece for its clarinet, but has the option to buy
it from a supplier. Fixed overhead costs will not
change whether or not Blue Tone chooses to make or to buy the mouthpiece.

17. it from a supplier. Fixed overhead costs will not
Make, Lease, or Buy
Blue Tone is currently manufacturing the mouthpiece for its clarinet, but has the option to buy
it from a supplier. Fixed overhead costs will not
change whether or not Blue Tone chooses to make or to buy the mouthpiece.

18. Make, Lease, or Buy
Quick Copy is considering an upgrade to the latest model copier that is not available for lease but must be purchased for $160,000. The purchased copier is useful for one year, after which it could be sold back to the manufacturer for $40,000. In addition, the new machine has a required annual service contract of $20,000.

19. Make, Lease, or Buy Lease Cost = Purchase Cost
Annual fee = Net purchase cost + service contract
$40,000 + $.02 × Q = ($160,000 - $40,000) + $20,000
Q = $100,000 ÷ $.02
= 5,000,000 copies
The indifference point, 5,000,000 copies, is lower than the expected annual machine usage of 6,000,000 copies. So, Quick copy should purchase the machine.

20. Make, Lease, or Buy Cost to Lease Copier Cost $120,000
$40,000
Number of Copies per Year
Cost
Cost to Lease Copier
Net cost to Purchase Copier
Q = 5,000,000

21. Sell Before or After Additional Processing
Malfunctioning equipment caused 400 T-shirts not to be of acceptable color. They can be sold to an outlet store for $1,800 ($4.50 each) or run them through the printing again. The cost of running the T-shirts through the printer a second time is the ink, supplies, and labor costs of $1.80 per shirt. In addition, setup, inspection, and materials handling costs for the batch will be incurred.

22. Sell Before or After Additional Processing
The net advantage to reprinting the T-shirts is $880 ($2,680 - $1,800).

23. Keep or Drop a Product or Service
Issues that should be addressed . . .
Which products are most profitable?
Are the products priced properly?
Which products should be promoted and advertised most aggressively?
Which product managers should be rewarded?

24. Keep or Drop a Product or Service
Windbreakers, Inc. manufactures three jackets. Management is concerned about the low profitability of the “Gale” jacket and is thinking about dropping the product. If the jacket is dropped, there will be no change in total fixed costs for the coming year.

25. Keep or Drop a Product or Service
The company is $15,000 better off retaining rather than deleting the “Gale” jacket.

26. Keep or Drop a Product or Service

27. Multiple Products and Limited Resources
The “Windy” and “Gale” jackets are manufactured in the same plant. Both jackets require an automated sewing machine for assembly. There are 3 machines that can be run up to 20 hours per day, 5 days per week (1,200 hours per month) at maximum capacity. The demand for both jackets exceeds the capacity of the 3 machines.
One Production Constraint

28. Multiple Products and Limited Resources
Slope = – 36,000 ÷ 24,000 = – 3/2 Intercept = 36,000
36,000 –
Units of Sales for Gale
Production constraint for sewing machine. All possible sales mixes are represented on this line.
24,000 –
Units of Sales for Windy

29. Multiple Products and Limited Resources
The completed jackets are inspected, labels added, and packaged. Forty workers are required for this operation. Each of the 40 workers actually works 35 productive hours per week. So, 5,600 hours are available per month for inspecting and packaging.
Two Production Constraint

30. Multiple Products and Limited Resources
67,200 –
Production constraint for Inspection and Packaging
36,000 –
Maximum contribution margin
Units of Sales for Gale
Production constraint for sewing machine
22,400 –
Units of Sales for Windy
24,000 –

31. Multiple Products and Limited Resources
67,200 –
15W + 5G = 35 × 40 × 4 × 60 = 336,000 minutes 3W + 2G = 400 × 3 × 60 = 72,000 minutes
W = 20,800 G = 4,800
36,000 –
Maximum contribution margin
Units of Sales for Gale
22,400 –
Units of Sales for Windy
24,000 –

32. Behavioral, Implementation, and Legal Issues
Management Incentives
Predatory Pricing
Replacing Variable Costs with Fixed Costs
Focus on Irrelevant Factors

33. End of Chapter 10