1. Relevant Costs and Benefits for Decision Making
Module 17
Relevant Costs and Benefits for Decision Making
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2. Distinguish between relevant and irrelevant revenues and costs.1
Distinguish between relevant and irrelevant revenues and costs.
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3. Relevant and Irrelevant Costs
Future costs that differ among competing decision alternatives
Future costs that DO NOT differ among competing decision alternatives
Primary focus is profit maximization
Additional factors that must be considered
Effects on long-run profit
Nonquantitative factors
Such as legal, ethical, social
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4. Future Revenues and Outlay Costs
Relevant if they differ between alternatives
Outlay costs
Outlay costs require future expenditures of cash or other resources
Relevant outlay costs
Outlay costs that differ between decisions
Irrelevant outlay costs
Outlay costs that do not differ between decisions
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5. Sunk Costs Result from past decisions that cannot be changed
Sunk costs are NEVER relevant
Sunk costs in decisions to replace a machine
Cost of old machine
Book value of old machine
Can cause ethical dilemmas
Managers often avoid disposing of old assets
Disposing may create a loss on the income statement, making the manager’s performance look bad
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6. Disposal and Salvage Values
Disposal value
Amount of cash an old asset can be sold for at the time the new asset is purchased
Relevant cash inflow
Obtained only if the replacement alternative is accepted
Salvage value
Amount of cash an asset will bring at the end of its useful life if held to that time
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7. Opportunity Costs
Any benefit forgone as a result of rejecting one alternative in favor of another
Always relevant when making decisions among competing alternatives
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8. Summary of Relevant and Irrelevant Costs
Remember that the deciding factor in whether or not a cost is relevant is if the cost differs among alternatives.
Only relevant costs are used in decision making.
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9. 2
Analyze relevant costs and indicate how they differ under alternative decision scenarios.
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10. Relevant and Irrelevant Costs Example
Trekker Tires manufacturers lawn mower tires It produces and sells 10,000 tires annually at a selling price of $20 each.
Management is evaluating the desirability of replacing the old assembly machine with a new machine. Data concerning the two machines:
Old Machine
Proposed Machine
Cost
$90,000
$80,000
Estimated useful life
6 years
4 years
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11. Relevant and Irrelevant Costs Example
Old Machine
Proposed Machine
Unit level:
Direct materials
$3.00 per unit
Conversion
$5.00 per unit
$3.50 per unit
Selling and distribution
$1.00 per unit
Batch level:
Inspection and adjustment
$500 per batch
$400 per batch
Batch size
1,000
Direct labor and variable manufacturing overhead required to convert raw materials into finished goods.
The old machine is two years old with a current disposal value of $35,000. The proposed machine has a zero salvage value.
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12. Relevant and Irrelevant Costs Example
Old Machine
Proposed Machine
Unit level:
Direct materials
$3.00 per unit
Conversion
$5.00 per unit
$3.50 per unit
Selling and distribution
$1.00 per unit
Batch level:
Inspection and adjustment
$500 per batch
$400 per batch
Batch size
1,000
Difference in conversion costs
Disposal value of old machine
Difference in batch costs
Difference in depreciation
Direct material costs
Selling and distribution costs
Cost of old machine
Selling price of tires
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13. Differential Analysis
An approach to the analysis of relevant costs that focuses on costs that differ between alternative actions
Preferred over an aggregate analysis when determining which of two alternatives is most profitable
Benefits
Focuses on only items that differ
Contains fewer items, making it easier and quicker to prepare
Helps simplify complex situations
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14. Apply differential analysis to evaluate changes in profit plans.3
Apply differential analysis to evaluate changes in profit plans.
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15. Changes in Profit Plans Example
KonnectCo manufactures flash drives and sells them for €20 (euros). Management is considering 3 possible alternatives:
Proposed Change
Expected Effect on Units Sold
Alternative #1
Increase advertising by €1,000
Sales increase by 300 units
Alternative #2
Increase unit selling price by €1
Sales decrease by 300 units
Alternative #3
Decrease unit selling price by €1
Sales increase by 500 units, with direct labor for the last 200 units increasing by €1 each due to overtime
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16. Changes in Profit Plans Example
Current costs to produce flash drives are:
Variable Costs per Unit
Direct materials €3
Direct labor 4
Manufacturing overhead 2
Selling and administrative 1
Fixed Costs per Month
Manufacturing overhead €20,000
Selling and administrative 8,000
Average monthly production and sales is 4,000 units.
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17. Changes in Profit Plans Example
Alternative #1
Increase advertising by €1,000, with sales increasing by 300 units
Unit contribution margin = €20 – (€3 + €4 + €2 + €1) = €10
Differential Analysis
Profit increase from increased sales
(300 units × €10)
€3,000.
Profit decrease from increased advertising
(1,000)
Increase in monthly profit
€2,000.
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18. Changes in Profit Plans Example
Alternative #2
Increase selling by €1, with sales decreasing by 300 units
Unit contribution margin = €20 – (€3 + €4 + €2 + €1) = €10
Differential Analysis
Profit decrease from reduced sales (300 units × €10)
€(3,000)
Profit increase from increased selling price (3,700 units × €1)
3,700.
Increase in monthly profit €
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19. Changes in Profit Plans Example
Alternative #3
Decrease selling by €1, with sales increasing by 500 units, causing the last 200 units to incur overtime on direct labor costing €1 per unit more
Unit contribution margin = €20 – (€3 + €4 + €2 + €1) = €10
Differential Analysis
Profit increase from additional sales units × (€19 – (€3 + €4 + €2 + €1))
€4,500.
Profit decrease from decreased selling price (4,000 units × €1)
(4,000)
Profit decrease from overtime on 200 units (200 units × €1)
(200)
Increase in monthly profit €
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20. Changes in Profit Plans Example
Alternatives
#1 Increase monthly profit € 2,000
#2 Increase monthly profit €
#3 Increase monthly profit €
The best option is Alternative #1 because it results in the largest increase in profit.
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21. 4
Apply differential analysis to evaluate whether to accept a special order.
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22. Special Orders
Occurs when a customer wants to buy merchandise or obtain services on a “one time” basis at a price less than prices charged to other customers
Usually involves a proposed purchase of a large volume of units
What is relevant?
Sales revenue
Variable production costs
Additional costs to be incurred
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23. Variable Costs per Unit
Special Order Example
A customer offers to place a special, one-time order for 800 units at a reduced price of €16 per unit. KonnectCo has production capacity of 5,000 units and normally produces 4,200. KonnectCo will save 25% of its variable sales and administrative costs as a result. Should KonnectCo accept the order?
Variable Costs per Unit
Direct materials €3
Direct labor 4
Manufacturing overhead 2
Selling and administrative 1
Fixed Costs per Month
Manufacturing overhead €20,000
Selling and administrative 8,000
KonnectCo’s Costs
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24. Differential Analysis
Special Order Example
Differential Analysis
Increase in revenues (800 units × €16)
€12,800.
Increase in costs
Direct materials (800 × €3)
€2,400
Direct labor (800 × €4)
3,200
Manufacturing overhead (800 × €2)
1,600
Selling and administrative (800 × €1 × 75%)
600
(7,800)
Increase in profits
€ 5,000.
KonnectCo should accept the order since its profits will increase by €5,000.
The fixed portion of the selling and administrative costs remain at €8,000 no matter what level of activity. The special cost savings are for variable costs.
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25. Concerns with Special Orders
Time span concerns
Future year cost increases should be considered in multiyear special orders
Variable nature of long-term fixed costs
In the long-run, all costs, fixed and variable, should be considered relevant
Because they are subject to change over time
Possible solutions
Include a cost escalation clause in multiyear agreements
Use full costs regardless of cost behavior patterns to approximate long-run variable costs
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26. Multiyear Special Order Example
What if the customer wanted KonnectCo to sign a multiyear contract to provide 800 units per month at €16 each?
Full cost based on capacity
Direct materials
€3.00
Direct labor
4.00
Variable manufacturing overhead
2.00
Variable selling and administrative
0.75
Fixed manufacturing overhead (€20,000 / 5,000)
Fixed selling and administrative (€8,000 / 5,000)
1.60
Average full cost per unit
€15.35
KonnectCo should consider accepting a multiyear order based on full costs because €16 exceeds the full cost.
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27. Special Order with Opportunity Costs Example
What if KonnectCo were operating at capacity, its regular customers pay €20 per flash drive, and the special order customer wants to buy 800 units per month at €16 each?
Lost sales to regular customers (units)
800.
Regular unit contribution margin [€20 – (€3 + €4 + €2 + €1)] €
Opportunity cost of accepting the special order
(8,000)
Increase in profit if special order accepted
[€16 – (€3 + €4 + €2 + €.75)]
5,000.
Net decrease in profit is special order accepted
(€3,000)
KonnectCo’s profits would decrease by €3,000 if the special order is accepted if operating at capacity.
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28. Qualitative Considerations of Special Orders
Impact on regular customers
Potential long-term benefits from the special order customer
Trying to establish a customer relationship
Legal factors
Does the buyer compete with regular customers?
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29. Apply differential analysis to evaluate outsourcing decisions.5
Apply differential analysis to evaluate outsourcing decisions.
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30. Outsourcing
Outsourcing is the procurement of services, products, components from an external source.
Possible reasons for outsourcing include:
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31. Variable Costs per Unit
Outsourcing Example
Variable Costs per Unit
Direct materials €3
Direct labor 4
Manufacturing overhead 2
Selling and administrative 1
Fixed Costs per Month
Manufacturing overhead €20,000
Selling and administrative 8,000
KonnectCo’s Costs
A manufacturer has offered to supply KonnectCo with all the flash drives it needs for one year at a cost of €9 each. If accepted, KonnectCo could eliminate production supervisor salaries that currently cost €1,000 per month. Normal production is 4,200 units each month.
Should KonnectCo outsource?
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32. Outsourcing Example
There are no relevant revenues in outsourcing decisions.
Cost to buy (€9 × 4,200 × 12 months)
€453,600
Cost to make:
Direct materials (€3 × 4,200 × 12)
€151,200
Direct labor (€4 × 4,200 × 12)
201,600
Variable manufacturing overhead
(€2 × 4,200 × 12)
100,800
Fixed manufacturing overhead
(€1,000 × 12)
12,000
Total
€465,600
Advantage of buying
€ 12,000
KonnectCo should consider outsourcing as profits will be higher by €12,000.
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33. KonnectCo should consider outsourcing to increase profits by €27,000.
Outsourcing Example
If the space currently used to manufacture can be rented for €15,000 per year, what should KonnectCo do?
Cost to buy (€9 × 4,200 × 12 months)
€453,600
Cost to make:
Direct materials (€3 × 4,200 × 12)
€ 151,200
Direct labor (€4 × 4,200 × 12)
201,600
Variable manufacturing overhead (€2 × 4,200 × 12)
100,800
Fixed manufacturing overhead (€1,000 × 12)
12,000
Opportunity cost of lost rental income if manufactured
15,000 .
Total
€ 480,600
Advantage of buying
€ 27,000
KonnectCo should consider outsourcing to increase profits by €27,000.
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34. 6
Apply differential analysis to evaluate whether to sell or further process a product.
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35. Sell or Process Further Decisions
Key issue is to determine a product’s most advantageous selling point for products salable at various stages of completion
Decision is whether
To sell the product ‘as is’
Process the product further to sell for a higher selling price
Two types of decisions
Single products
Joint products
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36. Sell or Process Further Decision Example
Stack’Em manufactures assembled, ready-to-paint book shelves for $18 each and sells them for $30 each. Painting the shelves would increase the total cost of a shelf to $23, but Stack’Em could then sell them for $38 each. What should Stack’Em do?
Increase in revenues:
Revenue per shelf if painted
$38
Revenue per shelf if sold without paint 30
$ 8.
Additional costs of painting
($23 – $18)
(5)
Advantage of painting for each shelf
$ 3.
Stack’Em should paint the shelves as profit increases by $3 per shelf.
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37. Joint Product Cost Decisions
What are joint products?
Two or more products simultaneously produced by a single process from a common set of inputs
Split-off point
The point in the process where the joint product becomes separately identifiable
Joint costs
Costs incurred prior to the split-off point
Are sunk costs and never relevant to joint product decisions or to process further decisions
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38. 7
Allocate limited resources for purposes of maximizing short-run profit.
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39. Use of Limited Resources
Managers should decide how to best use limited resources to accomplish organizational goals.
Sometimes results in a product mix decision, i.e., which product should be produced with the limited resource?
Examples of limited resources
Limited capacity
Limited labor hours due to lack of skilled labor
Limited materials due to supply limitations
Limited machine hours
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40. Use of Limited Resources Single Constraint—Example
Wilson Sports produces two models of baseball bats using white ash wood. Due to weather problems, wood supply is limited and Wilson is able to obtain only 24,000 board feet of white ash.
Which bat should Wilson produce given the following information?
Deluxe Bats
Basic
Bats
Unit selling price
$75
$54
Unit variable costs 34 25
Unit contribution margin
$41
$29
Number of board feet of wood needed per bat
3.40
2.20
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41. Use of Limited Resources Single Constraint—Example
Determine the contribution margin per board foot for each product.
Deluxe Bats
Basic
Bats
Unit contribution margin
$41
$29
Number of board feet of wood needed per bat
3.40
2.20
Contribution margin per board foot:
$41 / 3.40 =
$12.06
$29 / 2.20 =
$13.18
Deluxe bats generate $12.06 of profit for every board foot of white ash wood used, while basic bats generate $ Therefore, basic bats should be produced.
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42. Use of Limited Resources Multiple Constraint—Example
Assume that Wilson Sports must produce at least 2,000 of each model to remain competitive. With the same material constraint of 24,000 board feet of white ash, how much will total contribution margin be when profit is maximized under the constraint?
Deluxe: Contribution per board foot: $41/3.40 = $12.06
Basic: Contribution per board foot: $29/2.20 = $13.18
Produce more basic bats since they generate more contribution to profit per board foot than do the deluxe bats.
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43. Use of Limited Resources Multiple Constraint—Example
Subtract the board foot to be used for the minimum units of the least profitable product from available wood:
Available board feet
24,000.
Feet to be used for minimum deluxe bats (3.4 × 2,000)
(6,800)
Remaining feet to be used for basic bats
17,200.
Determine the number of basic bats to be produced with the remaining board feet:
Number of basic bats to be produced (17,200 / 2.20) = 7,818
Contribution margin generated:
Contribution margin from deluxe bats ($41 × 2,000)
$ 82,000
Contribution margin from basic bats ($29 × 7,818)
226,722
Total contribution margin
$308,722
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44. A bottleneck is a constraining resource.
Theory of Constraints
States that
Every process has a bottleneck, and
Production cannot take place faster than it is processed through the bottleneck
Goal is to maximize throughput in a constrained environment
Throughput is sales revenue minus direct materials cost
A bottleneck is a constraining resource.
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45. Management’s Role in Bottlenecks
Management should…
Identify the bottlenecks
Schedule production to maximize the efficient use of the bottleneck resource
Schedule production to avoid a buildup of inventory
Work to eliminate bottlenecks
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46. Theory of Constraints
To support the theory of constraints, performance reports should:
Measure the utilization of bottleneck resources
Measure factory throughput
Not encourage the full utilization of non-bottleneck resources
Discourage the buildup of excess inventory
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