1. Relevant Information and Decision Making: Production Decisions
Chapter 10
Relevant Information
and Decision Making:
Production Decisions

2. Learning Objective 1
Use opportunity cost to
analyze the income
effects of a given
alternative.

3. Costs An opportunity cost is the maximum available
contribution to profit forgone (or passed up)
by using limited resources for a particular purpose.
An outlay cost requires a cash disbursement.

4. Costs
Differential cost and incremental cost are defined as the difference in total cost between two alternatives.

5. Learning Objective 2
Decide whether to make or buy
certain parts or products.

6. Make-or-Buy Decisions
The basic make-or-buy question is whether a company should make its own parts to be used in its products or buy them from vendors.

7. Make-or-Buy Decisions
Qualitative Factors:
Control quality
Protect long-term relationships with suppliers
Quantitative Factors: Idle facilities or capacity

8. Make-or-Buy Example GE Company Cost of Making Part N900:
Total Cost for Cost
20,000 Units per Unit
Direct material $ 20,000 $ 1
Direct labor ,
Variable overhead ,
Fixed overhead ,
Total costs $220,000 $11

9. Make-or-Buy Example
Another manufacturer offers to sell GE the same part for $10.
The essential question is the difference in expected future costs between the alternatives.
Should GE make or buy the part?

10. Make-or-Buy Example
If the $4 fixed overhead per unit consists of costs that will continue regardless of the decision, the entire $4 becomes irrelevant.
If $20,000 of the fixed costs will be eliminated if the parts are bought instead of made, the fixed costs that may be avoided in the future are relevant.

11. Relevant Cost Comparison
Make Buy
Total Per Unit Total Per Unit
Purchase cost $200,000 $10
Direct material $ 20,000 $ 1
Direct labor ,
Variable overhead ,
Fixed OH avoided by
not making ,
Total relevant costs $160,000 $ 8 $200,000 $10
Difference in favor
of making $ 40,000 $ 2

12. Learning Objective 3
Decide whether a joint product
should be processed beyond
the split-off point.

13. Joint Products Joint products have relatively significant
sales values.
They are not separately identifiable as
individual products until their split-off point.
The split-off point is that juncture of
manufacturing where the joint products
become individually identifiable.

14. Joint Products Separable costs are any costs beyond the
split-off point.
Joint costs are the costs of manufacturing
joint products before the split-off point.

15. Illustration of Joint Costs
Suppose Dow Chemical Company produces two chemical products, X and Y, as a result of a particular joint process.
The joint processing cost is $100,000.
Both products are sold to the petroleum industry to be used as ingredients of gasoline.

16. Illustration of Joint Costs
1 million liters of X at a
selling price of $.09 = $90,000
Joint-processing
cost is $100,000
500,000 liters of Y at a
selling price of $.06 = $30,000
Total sales value at split-off
is $120,000
Split-off point

17. Illustration of Sell or Process Further
Suppose the 500,000 liters of Y can be processed further and sold to the plastics industry as product YA.
The additional processing cost would be $.08 per liter for manufacturing and distribution, a total of $40,000.
The net sales price of YA would be $.16 per liter, a total of $80,000.

18. Illustration of Sell or Process Further
Sell at
Split-off
as Y
Process
Further and
Sell as YA
Difference
Revenue $30,000 $80,000 $50,000
Separable costs
beyond split-off
@ $ – , ,000
Income effects $30,000 $40,000 $10,000

19. Learning Objective 4
Identify irrelevant information
in disposal of obsolete inventory
and equipment replacement
decisions.

20. Irrelevance of Past Costs
Two examples of past costs that we can consider, to see why they are irrelevant to decisions, are:
The cost of obsolete inventory
The book value of old equipment

21. Example of Irrelevance of Obsolete Inventory
Suppose General Dynamics has 100 obsolete aircraft parts in its inventory.
The original manufacturing cost of these parts was $100,000.

22. Example of Irrelevance of Obsolete Inventory
General Dynamics can...
remachine the parts for $30,000 and then sell them for $50,000, or
scrap them for $5,000.
Which should it do?

23. Example of Irrelevance of Obsolete Inventory
Remachine Scrap Difference
Expected future revenue $ 50,000 $ 5,000 $45,000
Expected future costs , ,000
Relevant excess of
revenue over costs $ 20,000 $ 5,000 $15,000
Accumulated historical
inventory cost* , ,
Net loss on project $(80,000) $ (95,000) $15,000
*Irrelevant because it is unaffected by the decision.

24. Irrelevance of Book Value of Old Equipment
The book value of equipment is not a
relevant consideration in deciding
whether to replace the equipment.
Why?
Because it is a past, not a future cost.

25. Irrelevance of Book Value of Old Equipment
Depreciation is the periodic allocation of the cost
of equipment.
The equipment’s book value (or net book value)
is the original cost less accumulated depreciation.

26. Example of Book Value Computation
Suppose a $10,000 machine with a 10-year life
has depreciation of $1,000 per year.
What is the book value at the end of 6 years?
Original cost $10,000
Accumulated depreciation (6 × $1,000) 6,000
Book value $ 4,000

27. Keep or Replace an Old Machine?
Old Replacement
Machine Machine
Original cost $10,000 $8,000
Useful life in years
Current age in years
Useful life remaining in years
Accumulated depreciation $ 6,
Book value $ 4, N/A
Disposal value (in cash) now $ 2, N/A
Disposal value in 4 years
Annual cash operating costs $ 5,000 $3,000

28. Keep or Replace an Old Machine?
What is a sunk cost?
A sunk cost is a cost that has already been incurred and, therefore, is irrelevant to the decision-making process.

29. Relevance of Equipment Data
In deciding whether to replace or keep existing equipment, we must consider the relevance of four commonly encountered items:
Book value of old equipment
Disposal value of old equipment
Gain or loss on disposal
Cost of new equipment

30. Book Value of Old Equipment
The book value of old equipment is irrelevant because it is a past (historical) cost.
Therefore, depreciation on old equipment is irrelevant.

31. Disposal Value of Old Equipment
The disposal value of old equipment is relevant (ordinarily) because it is an expected future inflow that usually differs among alternatives.

32. Gain or Loss on Disposal
This is the difference between book value and disposal value.
It is therefore a meaningless combination of irrelevant (book value) and relevant items (disposal value).
It is best to think of each separately.

33. Cost of New Equipment
The cost of the new equipment is relevant because it is an expected future outflow that will differ among alternatives.
Therefore depreciation on new equipment is relevant.

34. Comparative Analysis of the Two Alternatives
Four Years Together
Keep Replace Difference
Cash operating costs $20,000 $12,000 $ 8,000
Old equipment (book value)
depreciation, or ,000 – –
lump-sum write-off ,000 –
Disposal value – (2,500) 2,500
New machine
acquisition cost – ,000 (8,000)
Total costs $24,000 $21,500 $ 2,500

35. Learning Objective 5
Explain how unit costs
can be misleading.

36. Beware of Unit Costs
There are two major ways to go wrong when using unit costs in decision making:
The inclusion of irrelevant costs
Comparisons of unit costs not computed on the same volume basis

37. Example of Volume Basis Decision
Assume that a new $100,000 machine with a five-year life can produce 100,000 units a year at a variable cost of $1 per unit, as opposed to a variable cost per unit of $1.50 with an old machine.
Is the new machine a worthwhile acquisition?

38. Example of Volume Basis Decision
Old New
Machine Machine
Units , ,000
Variable cost per unit $ $1.00
Variable costs $150,000 $100,000
Straight-line depreciation ,000
Total relevant costs $150,000 $120,000
Unit relevant costs $ $1.20

39. Example of Volume Basis Decision
It appears that the new machine will reduce costs by $.30 per unit.
However, if the expected volume is only 30,000 units per year, the unit costs change in favor of the old machine.

40. Example of Volume Basis Decision
Old New
Machine Machine
Units , ,000
Variable cost per unit $ $1.00
Variable costs $45,000 $30,000
Straight-line depreciation ,000
Total relevant costs $45,000 $50,000
Unit relevant costs $1.50 $1.6667

41. Learning Objective 6
Discuss how performance
measures can affect
decision making.

42. Performance Measures Can Affect Decision Making
To motivate managers to make the right choices, the method used to evaluate performance should be consistent with the decision model.

43. Example of Affect on Decision Making
Consider the replacement decision, discussed earlier, where replacing the machine had a $2,500 advantage over keeping it.
Because performance is often measured by accounting income, consider the accounting income in the first year after replacement compared with that in years 2, 3, and 4.

44. Example of Affect on Decision Making
Year Years 2, 3, and 4
Keep Replace Keep Replace
Cash operating
costs $5,000 $3,000 $5,000 $3,000
Depreciation 1, , , ,000
Loss on disposal
($4,000 – $2,500) $1,
Total charges
against revenue $6,000 $6,500 $6,000 $5,000

45. Example of Affect on Decision Making
If the machine is kept rather than replaced,
first-year costs will be $500 lower
($6,500 – $6,000), and first-year
income will be $500 higher.

46. Learning Objective 7
Construct absorption and
contribution format income
statements and identify which
is better for decision making.

47. Absorption Approach
The absorption approach is a costing approach that considers all factory overhead (both variable and fixed) to be product (inventoriable) costs.
Factory overhead becomes an expense in the form of manufacturing cost of goods sold only as sales occur.

48. Contribution Approach
In contrast, the contribution approach is used by many companies for internal (management accounting) reporting.
It emphasizes the distinction between variable and fixed costs.
The contribution approach is not allowed for external financial reporting.

49. Comparing Contribution and Absorption Approaches
Manufacturing
costs
Nonmanufacturing
costs
Variable
costs
A. Variable
manufacturing
costs
B. Variable
nonmanufacturing
costs
Fixed
costs
C. Fixed
manufacturing
costs
D. Fixed
nonmanufacturing
costs

50. End of Chapter 6