Fundamental Managerial Accounting Concepts

Fundamental Managerial Accounting Concepts
Eighth Edition Chapter 6 Relevant Information for Special Decisions Chapter 6: Relevant Information for Special Decisions This chapter explains how to isolate and focus on the variables that are relevant in the decision-making process. Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objective 1: Identify the characteristics of relevant information.
Learning objective number 1 is to identify the characteristics of relevant information.

Relevant Information Two primary characteristics distinguish relevant from useless information: Relevant information differs among the alternatives under consideration. Relevant information is future oriented. We can identify relevant information by looking at two characteristics: First, relevant information differs among the alternatives being considered by the manager, and second, relevant information is future oriented; that is it involves amounts that will impact future operations. A great deal of information that may appear to be relevant at first glance may in fact not meet both of the characteristics we’ve just discussed. When information fails to meet these two conditions it is irrelevant to the decision process and must be ignored.

Sunk Cost A sunk cost has been incurred in a past transaction and cannot be changed. It is not relevant for making current decisions. Person 1: 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! Person 2: 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. Person 1: don’t want to take the loss! Person 2: Just sell the stock and buy the car! Part I A sunk cost is one that has been incurred in the past and cannot be changed regardless of the events we currently face. Sometimes individuals have emotional attachments to some costs that color the decision process. Part II Here is a perfect example of a sunk cost. A person has purchased some stock paying $25,000 cash. The stock has dropped in value to $15,000. The individual really needs a new car but doesn’t have enough cash to purchase one. His coworker suggests he sell the stock for $15,000 and buy the car. The purchase price of the stock, $25,000, is not relevant to the decision to purchase the car. The purchase price of the stock is a sunk cost and cannot be changed. Part III The coworker tries to explain that the person has already taken a loss on the $25,000 original investment and that that $25,000 is a sunk cost. If you really need a car, just sell the stock and buy the car. The emotional response from the coworker is “I just don’t want to take the loss.”

Opportunity Costs An opportunity cost is the sacrifice that is incurred in order to obtain an alternative opportunity. Person 1: The opportunity cost of owning the stock is $15,000. That is the amount you could receive if you decide to sell. Person 2: I think I am beginning to see what you mean. An opportunity cost is the sacrifice that is incurred in order to obtain an alternative opportunity. In our case the opportunity cost of owning the stock is $15,000, because that is the amount that could be received if the owner sells the stock.

Relevance is an Independent Concept (1 of 2)
Management at Better Bakery Products is debating whether to add a new product, either cakes or pies, to the company’s product line. Projected costs are shown: Cost of Cakes Materials (per unit) $ 1.50 Direct labor (per unit) 1.00 Supervisor's salary 25,000.00 Franchise fee 50,000.00 Part I Here we have the situation where a company is attempting to decide whether to add cakes or pies to its product line. Take a look at the cost information that applies to the cakes and the pies. Part II Under either alternative a new production supervisor must be hired at a cost of $25,000 per year. The cakes are distributed under a nationally advertised label and therefore requires no additional advertising. Pies are marketed under the company’s own name and will require an advertising campaign. Let’s see how we identify relevant costs. Cost of Pies Materials (per unit) $ 2.00 Direct labor (per unit) 1.00 Supervisor's salary 25,000.00 Advertising 40,000.00

Relevance is an Independent Concept (2 of 2)
Under either alternative, a new production supervisor must be hired at a cost of $25,000 per year. Cakes are distributed under a nationally advertised label. Pies are marketed under the company’s own name and will require new advertising. Which costs are relevant? Material costs are relevant because they differ. Fifty cents can be avoided by choosing cakes instead of pies. Labor costs and the supervisor’s salary are not relevant because they do not differ. The advertising costs can be avoided if the company elects to make cakes. The franchise fee can be avoided if the company elects to make pies. Whether a cost is fixed or variable has no bearing on its relevance. If we choose cakes instead of pies we can avoid $.50 in material costs. Labor costs do not differ and are therefore not relevant. The supervisor’s salary is not relevant because it does not differ under the two alternatives. The advertising costs can be avoided if the company decides to make cakes rather than pies, but the franchise fee can be avoided if the company decides to make pies. In determining whether a cost is relevant or not it makes no difference whether it’s a fixed cost or a variable cost.

Relevance is Context-Sensitive (1 of 2)
A particular cost that is relevant in one context may be irrelevant in another. A department store sells men’s, women’s, and children’s clothing. The store manager’s salary could not be eliminated if the store eliminated the line of children’s clothing. Is the store manager’s salary relevant to the decision to stop selling children’s clothing? No, the store manager’s salary will be the same if children’s clothing is no longer sold. Part I Any given cost may be relevant in one context and irrelevant in another. Consider a department store that sells men’s, women’s, and children’s clothing. The store manager’s salary will not be eliminated if management decides to eliminate the store’s line of children’s clothing. Is the manager’s salary relevant to the decision to stop selling children’s clothing? Part II No, there would be no difference in the store manager’s salary if the children’s clothing was no longer sold.

Relevance is Context-Sensitive (2 of 2)
Would the store manager’s salary be a relevant cost, if the company was thinking about closing the store completely? Yes, it is a relevant cost. If the store remains open, the company will incur the manager’s salary. If the store is closed, the cost will be eliminated. Part I Do you think the store manager’s salary is a relevant cost if top management is considering closing the store completely? Part II In this new context, the store manager’s salary is a relevant cost. If the store remains open the company will continue to incur the manager’s salary. If the store is closed, the company will not incur the cost. So, the store manager’s salary is a relevant cost in the context we outlined.

Relationship Between Relevance and Accuracy
Information need not be exact to be relevant. You may be considering the purchase of a laptop computer. You may decide to delay your decision because you think the price will decrease. You are not sure of the amount of the price drop, but you do believe part of the cost can be avoided by waiting. Information does not need to be exact to be relevant to your decision process. For example, you may be considering the purchase of a laptop computer, but have reason to believe that the price will drop in the near future. You do not know the exact amount of the anticipated price reduction, but you do believe part of the cost of the computer can be avoided by waiting. However, the most useful information is both relevant and precise.

Quantitative Versus Qualitative Characteristics (1 of 2)
Relevant information can have both quantitative and qualitative characteristics. 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 Part I Relevant information can have both quantitative and qualitative characteristics. A quantitative focus considers the cost, increase in profits, or other numerical aspects of the decision. A qualitative focus considers non-quantitative aspects such as the impact on people and attractiveness of the products. Part II 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. From a quantitative standpoint, you would select Computer B because it is $300 less. However, if Computer A’s appearance (a qualitative aspect) will impress clients, you may be inclined to purchase Computer A rather than Computer B. In this case, the qualitative difference is more important than the quantitative difference.

Quantitative Versus Qualitative Characteristics (2 of 2)
Computer A Computer B

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. Avoidable costs are the costs managers can eliminate by making specific choices. Like relevant costs, relevant revenues must be future oriented and differ between the alternatives under consideration. Relevant revenues are sometimes referred to as differential revenues. In our clothing store example, the store’s revenue would be impacted if the decision was made to eliminate the children’s clothing line. Total revenue would be lower as a result of the decision to stop selling children’s clothing. Avoidable costs are the costs managers can eliminate by making specific choices. For example, a departmental manager’s salary is avoidable if the department is eliminated. However, the cost of the president’s salary is not avoidable because the company will need a president even if an individual department is eliminated.

Relevant (Avoidable) Costs
Unit-level Costs: Avoided by eliminating one unit of product. Batch-level Costs: Avoided when a batch of work is eliminated. Product-level Costs: Avoided if a product line is eliminated. Facility-level Costs: Some costs may be avoided if a business segment is eliminated. Part I In this chapter we will discuss relevant costs as falling into one of four categories. Part II The first category is known as unit level activities. These are costs that can be avoided by eliminating just one unit of product. Part III Batch level costs can be avoided when an entire batch of work is eliminated. Part IV Product level costs, incurred to support specific products or services, can be avoided if we eliminate a product line. Part V Facility level costs, which are incurred to support the entire company, are more difficult to avoid but some of these costs may be avoided if a product line is eliminated.

Check Yourself Aqua, Inc., makes statues for use in fountains. On January 1, 2016, the company paid $13,500 for a mold to make a particular type of statue. The mold had an expected life of four years and a salvage value of $1,500. On January 1, 2018, the mold had a market value of $3,000, and a salvage value of $1,200. The expected useful life did not change. What is the relevant cost of using the mold during 2018? ($3,000 - $1,200) ÷ 2 years = $900 Of course, Aqua could avoid the cost by selling the mold for its market value of $3,000. Part I Read this information carefully about a mold purchased by Aqua to make statues for fountains. The mold was purchased on January 1, What we would like to know is what is the relevant cost of using the mold during 2018? Part II The correct answer is $900. We would take the market value of $3,000 less the salvage value of $1,200 and divide by the remaining life of 2 years. Part III There is another option however. Aqua could avoid the $900 cost by selling the mold for its market value of $3,000.

Learning Objective 2: Make appropriate special order decisions.
Learning objective number 2 is to make appropriate special order decisions.

Relevant Information and Special Decisions
Occasionally, a company receives an offer to sell its product at a price significantly below its normal selling price. The company must make a special order decision to accept or reject the offer. From time to time companies receive a one-time special order to sell its product at less than its normal selling price. Management must make a decision to accept or reject the offer. Let’s see how we frame this decision.

Exhibit 6.1 (1 of 2) Here is current budgeted production information for Premier Company. The company manufactures printers with a unit cost of each printer of $ You can see that the company has broken down its production costs into unit-level, batch-level, product-level, and facility-level costs. Premier has excess capacity and is able to produce more than 2,000 printers.

Exhibit 6.1 (2 of 2) Here is budgeted cost information for Premier, a company that produces printers. The company has enough capacity to produce additional printers, but is planning to produce to meet current demand. Cost per unit: $658,500 ÷ 2,000 = $

Special Order Decision (1 of 4)
A foreign customer offers to purchase 200 printers at $250 per printer. This price is well below the unit cost of $ Should the company accept this one time order? Relevant Information for Special Order Differential revenue ($250 ×200) $ 50,000 Avoidable unit-level costs ($180 × 200) (36,000) Avoidable batch-level costs: Assembly setup (1,700) Materials handling (500) Contribution to income $ 11,800 Part I A foreign customer offers to purchase 200 printers at $250 per printer. The offer price is substantially below the unit product cost. If you were the manager of Premier, would you accept this one time offer? Part II Step 1 in the decision process is to determine the amount of the differential revenue. In our example, the differential revenue is $50,000, that is 200 printers times $250 per printer. Step 2 is to determine the differential, or avoidable, costs. If we reject the offer, we could avoid $180 per printer of unit level costs for a total of $36,000. On average, 200 printers require one setup and material handling charges. We could also avoid one setup at $1,700 and material handling of $500. The third, and final step, is to make our decision to accept or reject the offer. This special one-time offer would contribute $11,800 to income, so we should accept the offer. If the order is accepted, profitability will increase by $11,800.

Opportunity Costs Premier has excess productive capacity. Suppose Premier has the opportunity to lease its excess capacity (unused building and equipment) for $15,000. Should Premier accept the special offer given this new information? Relevant Information for Special Order Differential revenue ($250 ×200) $ 50,000 Avoidable unit-level costs ($180 × 200) (36,000) Avoidable batch-level costs: Assembly setup (1,700) Materials handling (500) Opportunity cost (15,000) Contribution to income $ (3,200) Part I We know that Premier has excess productive capacity. Assume that Premier has the opportunity to lease its excess building space and equipment for $15,000. Would you still accept the special offer? Part II Adding the opportunity cost of $15,000 to our other avoidable costs, we find that the contribution to income is now a negative $3,200. Because profitability would decrease if we accept the special offer, we would reject the offer. If the order is accepted, profitability will decrease by $3,200.

Relevance and the Decision Context If Premier can increase income by selling its printers for $250, can the company reduce its normal selling price to $250? Part I If the one-time special offer proved profitable, could Premier afford to sell all of its printers at $250 each? Part II As you can see from our analysis, Premiere would lose $146,700 if it priced all of its 2,200 printers at $250 each; therefore, the company could not afford to sell its printers at $250 each.

Qualitative Characteristics Should a company ever reject a special order if the relevant revenues exceed the relevant costs? What will happen if Premier’s regular customers learn that the company sold printers to another buyer for $250 per unit? Part I Should a company ever reject a special order if the relevant revenues exceed the relevant costs? Qualitative characteristics may be even more important than quantitative ones in some cases. Part II What do you think would happen if Premier’s regular customers learn that the company sold printers to another buyer for $250 each? Most customers would ask for the same price. We saw that Premier cannot sell all its production for $250 per unit. Special order customers should come from outside Premier’s normal sales territory and special order customers should be advised that the special price does not apply to repeat business.

Learning Objective 3: Make appropriate outsourcing decisions.
Learning objective number 3 is to make appropriate outsourcing decisions.

Outsourcing Decisions (1 of 5)
Companies can sometimes purchase products needed in the manufacturing process for less than it would cost to make them. Buying goods and services from other companies rather than producing them internally is commonly called outsourcing. Student 1: That test was so easy. How did you score so low? Student 2: I outsourced my homework!! Part I Sometimes companies can purchase products needed in the manufacturing process at a cost lower than the cost to manufacture the product themselves. Purchasing from an outside supplier is referred to as outsourcing. Before we can successfully outsource we have to be assured that the quality of the product is the same as the quality of the product we manufacture and that delivery will be on a timely basis. If we are not very careful outsourcing may create more problems than it solves. Part II Here we have one student asking another why they did so poorly on the exam. The second student answers by saying that she outsourced her homework. As you have learned in this course doing your homework is an important part of preparing yourself for examinations.

Let’s return to our Premier example. Recall that the unit cost per printer was $ A supplier offers to sell an unlimited number of printers to Premier for $240 each. Should Premier accept this outsourcing offer? Step 1: Determine the production costs Premier can avoid if it elects to outsource printer production. Relevant Costs for 2,000 Printers Unit-level costs ($180 × 2,000) $ 360,000 Batch-level costs ($2,200 x 10) 22,000 Product-level costs 77,300 Total relevant cost $ 459,300 Part I An outside supplier offers to sell an unlimited number of printers to Premier for $240 each. Remember that the unit product cost to Premier was $ Do you think this is a good idea for Premier? Part II The first step is for Premier to determine the production costs that can be avoided if it elects to outsource the printers. As you can see the company can avoid its unit level, batch level and product level costs for a total of $459,300. Part III On a per-unit basis, the costs avoided amount to $ Let’s move on to the second step in the decision process. Cost per unit = $489, 300 ÷ 2,000 = $229.65

Step 2: Compare the avoidable production costs with the cost of buying the product and select the lower-cost option. Comparison Purchase price per unit $ Relevant cost per unit 229.65 In favor of manufacturing 10.35 Number of printers 2,000 Profit decline by outsourcing $ 20,700 Part I In the second step, we need to compare the avoidable production costs with the cost of buying the product from the outside supplier. We should select the lower-cost option. Part II As you can see on the schedule, there’s the $10.35 cost in favor of manufacturing as opposed to outsourcing. If we outsource profits are likely to decline by $20,700. Given these facts, Premier should reject the outsourcing offer. Premier should reject the outsourcing offer.

Opportunity Costs If Premier purchases the printers, it could use its manufacturing space for storing finished goods inventory. Premier is currently renting warehouse space at the cost of $40,000. Should Premier continue to manufacture the printers? Management should purchase the printers because the price of $240 is below the cost of $ when the opportunity cost is factored in. Part I If Premier purchases the printers from the outside manufacturer, it could use its current manufacturing space to store finished goods inventory. Currently, Premier is renting warehouse space for $40,000. Should we still continue to manufacture the printers. Part II When we add in the opportunity cost of $40,000, we see that the cost per unit to manufacture is $ The cost to purchase the printers from the outside manufacturer is $240 per unit, so it would be more profitable to purchase the printers than to continue manufacturing.

Relevant Costs for 2,000 Printers Unit-level costs ($180 × 2,000) $ 360,000 Batch-level costs ($2,200 x 10) 22,000 Product-level costs 77,300 Opportunity cost of warehouse 40,000 Total relevant cost $ 499,300 Cost per unit = $499, 300 ÷ 2,000 = $249.65

Evaluating Growth on the Level of Production (1 of 2)
The decision to outsource would change if expected production increases from 2,000 to 3,000 units. Some avoidable costs are fixed relative to production, so cost per unit decreases as volume increases. If Premier outsources the 3,000 printers it will save $40,000 currently being spent on warehouse space. Management should reject the offer, but if growth is expected in the future it must be factored into management’s decision. Part I The outsourcing decision may change if we expect increases in production. Some avoidable costs are fixed relative to production so the cost per unit decreases as volume increases. If Premier were to outsource 3,000 printers it has been determined that $40,000 of warehouse space could be saved. Part II Here we see the total of $690,300 could be avoided if we outsource 3,000 printers. Part III This would drop our average cost per unit avoided to $ Part IV Management would reject the offer because manufacturing is the low-cost option. However, if production is expected to increase significantly in the future we must continually analyze this offer.

Evaluating Growth on the Level of Production (2 of 2)
Relevant Costs for 3,000 Printers Unit-level costs ($180 × 3,000) $ 540,000 Batch-level costs ($2,200 × 15) 33,000 Product-level costs 77,300 Opportunity cost 40,000 Total relevant cost $ 690,300 Cost per unit = $690, 300 ÷ 3,000 = $230.10

Qualitative Features A company that uses vertical integration controls the full range of activities from acquiring raw materials to distributing goods and services. An oil company, like ExxonMobil, is a good example of vertical integration. Outsourcing reduces the level of vertical integration, passing some of a company’s control over its production to outside suppliers. A company that is vertically integrated controls the full range of activities from acquiring raw materials to distributing goods and services. An oil company like ExxonMobil is a good example of vertical integration. The company is in the oil exploration business, the refining business, and the distribution of products to final consumers. When a vertically integrated company outsources, it passes some of its control to outside suppliers.

Learning Objective 4: Make appropriate segment elimination decisions.
Learning objective number 4 is to make appropriate segment elimination decisions.

Segment Elimination Decisions
Businesses are frequently organized into operating units known as segments. Segment reports can be prepared for products, services, departments, branches, centers, offices, or divisions. These reports normally show segment revenues and costs. Let’s look at a segment report for Premier Office Products that has divided its operations into three segments: (1) copiers, (2) computers, and (3) printers. Most medium-size and large companies are organized into business units that may be referred to as segments. The segment can be a product line, a department, a division, or even a branch office. Let’s assume that Premier Office Products is divided into three segments. The first segment sells copiers, the second segment sells computers, and the third segment sells printers. The management at Premier is faced with the situation where one of the segments is operating at a loss. The question is, should that segment be eliminated.

Segment Elimination Decisions (1 of 2)
Copiers Computers Printers Total Project revenue $550,000 $850,000 $720,000 $2,120,000 Projected costs Unit-level costs Materials costs (120,000) (178,000) (180,000) (478,000) Labor costs (160,000) (202,000) (165,000) (527,000) Overhead (30,800) (20,000) (15,000) (65,800) Batch-level costs Assembly setup (26,000) (17,000) (58,000) Materials handling (6,000) (8,000) (5,000) (19,000) Product-level costs Engineering design (10,000) (12,000) (14,000) (36,000) Production manager salary (52,000) (55,800) (63,300) (171,100) Here is detailed information about the three segments and the whole company. Notice that we’ve arranged the information with our revenues and then our unit-level, batch-level, product-level, and facility-level costs, as well as our allocated corporate level costs. The allocation of corporate level costs is more or less arbitrary. The copier division is operating at a loss while the other two segments are reporting income. Should we eliminate the copier division?

Copiers Computers Printers Total Facility-level costs Segment level Division manager salary (82,000) (92,000) (85,000) (259,000) Administrative costs (12,200) (13,200) (12,700) (38,100) Allocated-corporate-level Company president salary (34,000) (46,000) (43,200) (123,200) Building rental (19,250) (29,750) (27,300) (76,300) General facility expenses (31,000) (93,000) Project income (loss) $(22,250) $136,250 $61,500 $175,500 Should management eliminate the copier segment?

A three step decision: Determine the amount of relevant revenue that pertains to eliminating the segment. Determine the amount of cost that can be avoided if the segment is eliminated. If the relevant revenue is less than the avoidable cost, eliminate the segment. If not, continue to operate it. The decision to eliminate a business segment can be divided into three steps. In the first step, we determine the amount of relevant revenue that pertains to eliminating the segment. In the second step, we do the same for costs. In the third step, if the relevant revenues are less than the avoidable costs we eliminate the segment. If this is not the case, we continue to operate the segment even though it shows a loss.

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. Step 2: If Premier eliminates copiers, it will avoid the following costs: In the first step, we know that if the copier segment is eliminated the company will lose $550,000 in revenue.

Unit-level costs Materials costs $ (120,000) Labor costs (160,000) Overhead (30,800) Batch-level costs Assembly setup (15,000) Materials handling (6,000) Product-level costs Engineering costs (10,000) Production manager salary (52,000) Facility-level costs Segment level Division manager salary (82,000) Administrative costs (12,200) Total relevant costs $ (488,000) In the second step, we determine the costs that will be eliminated if the copier segment is discontinued. Notice that the allocated corporate level costs are not avoidable but will merely be allocated to the remaining business segments. If Premier eliminates the copier segment, it will avoid $488,000 in costs.

Step 3: If Premier eliminates copiers, its profits will decrease: Revenue lost $(550,000) Costs avoided 488,000 Decrease in profit $(62,000) The corporate-level facility-sustaining costs will not be eliminated, but will be allocated to the remaining segments. If we eliminate the copier segment, overall profits will decrease by $62,000. Remember that the corporate level facilities sustaining costs will not be eliminated but will be allocated to the remaining two business segments.

Qualitative Considerations
Employee lives will be disrupted. Sales of different product lines are frequently interdependent. What will happen to the space freed by the eliminated segment? Volume changes can affect elimination decisions. If Premier eliminates the copier segment of its business, employees will be displaced and their lives will be disrupted. Management may cause some customers to seek other sources of office equipment, specifically, companies with broader product lines. There is the additional impact of the freed-up space that was previously allocated to the copier segment.

Relationships Between Avoidable Costs and Business Activities
Special order decisions affect unit-level and possibly batch-level costs. Outsourcing can avoid many product-level as well as unit- and batch-level costs. Segment elimination can avoid some of the facility-level costs. The more complex the decision level, the more opportunities there are to avoid costs. Generally, special order decisions affect unit-level and, in some cases, batch-level costs. Outsourcing decisions can avoid these two types of costs as well as product-level costs. Segment elimination may avoid all levels of costs, including facility-level costs. The more complex the decision level, the more opportunities there are to avoid costs.

Learning Objective 5: Make appropriate asset replacement decisions.
Learning objective number 5 is to make appropriate asset replacement decisions.

Equipment Replacement Decisions (1 of 2)
The equipment replacement decision should be based on profitability rather than physical deterioration. Consider the following: Old Machine Original cost $ 90,000 Accumulated depreciation (33,000) Book value $ 57,000 Market value (now) $ 14,000 Salvage value (in 5 years) 2,000 Annual depreciation expenses 11,000 Operating expenses ($9,000 × 5 years) 45,000 Equipment may become technologically obsolete long before it fails physically. Managers should base equipment replacement decisions on profitability analysis rather than physical deterioration. Premier Office Products is considering replacing an existing machine with a new one. You have been provided with the information on your screen and are to begin the process of deciding whether or not to replace the existing machine. New Machine Cost $ 29,000 Salvage value (in 5 years) 4,000 Operating expenses ($4,500 × 5 years) 22,500

Equipment Replacement Decisions (2 of 2)
Old Machine Opportunity cost $ 14,000 Salvage value (2,000) Operating expenses 45,000 Total $ 57,000 New Machine Cost $ 29,000 Salvage value (4,000) Operating expenses 22,500 Total $ 47,500 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). The relevant costs of keeping the existing machine are $57,000, and the relevant costs of purchasing the new machine are $47,500. The low-cost solution is to purchase the new machine. If we purchase the new machine, we will save a total of $9,500 over the next five years.

Equipment Replacement Decisions – Quantitative Analysis
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. The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement decision. 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). The $45,000 operating expenses of using the old machine can be avoided if it is replaced. It is a relevant cost. We begin the decision process by determining the relevant costs Premier will incur if it keeps the existing machine. The original cost, current book value, accumulated depreciation, and annual depreciation expense are not relevant because they are sunk costs. The market value of the existing machine is an opportunity cost and is relevant to the replacement decision. The salvage value of the existing machine reduces the opportunity cost. If we sell the existing machine in the market we will receive $14,000. If we keep the machine and sell it at the end of its useful life, we will receive $2,000. So, the opportunity cost is $12,000, that is, $14,000 minus $2,000. The $45,000 ($9,000 times 5 years) operating expenses associated with the existing machine can be avoided if it is replaced, so it is a relevant cost.

What are the relevant costs if Premier purchases and uses the new machine?
The cost of the new machine can be avoided by keeping the old machine. It is a relevant cost. The relevant cost of purchasing the new machine is $25,000 ($29,000 – $4,000). 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. Next, we determine what relevant costs will be incurred if Premier purchases and uses the new machine. First, we have the purchase price of the new machine. This cost could be avoided if we kept the existing machine, so the cost is relevant to the decision process. The relevant cost of purchasing the new machine is the purchase price of $29,000 minus salvage value in 5 years of $4,000. The operating expenses of the new machine over the five year period will be $22,500, and this is also a relevant cost. Now, let’s summarize the relevant costs of keeping the existing machine or purchasing the new machine.

Learning Objective 6: Explain the conflict between short-term and long-term profitability (Appendix). Learning objective number 6 is to explain the conflict between short-term and long-term profitability (Appendix).

Example (1 of 2) 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: Year First Second Third Fourth Fifth Totals Keep old machine Depreciation expense* $11,000 $55,000 Operating expense 9,000 45,000 Total $20,000 $100,000 Replace old machine Loss on disposal† $43,000 $0 Depreciation expense‡ 5,000 25,000 4,500 22,500 $52,500 $9,500 $90,500 Misguided reward systems can be as detrimental as threats of punishment. As this example shows, a manager may choose short-term profitability to obtain a bonus that is based on reported profitability. Therefore, it is the responsibility of upper-level management to establish policies and procedures that motivate subordinates to perform in ways that maximize the company’s long-term profitability.

Example (2 of 2) *($57,000 book value - $2,000 salvage) ÷ 5years = $11,000 † ($57,000 book value - $14,000 market value) = $43,000 ‡($29,000 cost - $4,000 Salvage) ÷ 5y 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. ears = $5,000

Learning Objective 7: Make decisions about allocating scarce resources (Appendix).
Learning objective number 7 is to make decisions about allocating scarce resources (Appendix).

Circumstances (1 of 2) Suppose that Premier Office Products makes two types of computers: a high-end network server and an inexpensive personal computer. The relevant sales and variable cost data for each unit follow. Network Server Sales price $4,000 Less: Variable cost (3,760) Contribution margin $240 In many circumstances, variable costs act as proxies for avoidable costs. To the extent that variable costs are proxies for avoidable costs, the contribution margin can be used as a measure of profitability. This helps companies understand the allocation of scarce resources. Many factors could limit the sales of one or both of the products for Premier Office Products. Factors that limit a business’s ability to satisfy the demand for its product are called constraints. Variable costs act as proxies for avoidable costs. Contribution margin can be used as a measure of profitability $ 240

Circumstances (2 of 2) Personal Computer
Sales price $1,500 Less: Variable cost (1,370) Contribution margin $130 Many factors could limit the sales of one or both of the products. Factors that limit a business’s ability to satisfy the demand for its product are called constraints. In many circumstances, variable costs act as proxies for avoidable costs. To the extent that variable costs are proxies for avoidable costs, the contribution margin can be used as a measure of profitability. This helps companies understand the allocation of scarce resources. Many factors could limit the sales of one or both of the products for Premier Office Products. Factors that limit a business’s ability to satisfy the demand for its product are called constraints.

Two Things To Consider SALES VOLUME: If Premier can sell considerably more of the personal computers, the volume of activity will make up for the lower margin. In other words, selling three personal computers produces more total margin (3 X $130 = $390) than selling one network server (1 x $240). TYPES OF CONSTRAINTS: If warehouse space is limited (i.e., the warehouse is a scarce resource that constrains sales), and the amount of space is the same for personal computers as network servers, then the product with the highest contribution margin per unit of scarce resource (warehouse square footage) is the more profitable product. The size of the warehouse is limiting production or causing a bottleneck. Other things being equal, higher contribution margins translate into more profitable products. If Premier could sell 1,000 computers, the company would certainly prefer that they be network servers. The contribution to profitability on those machines is almost double the contribution margin on the personal computer. If Premier can sell considerably more of the personal computers, the sales volume will make up for the lower margin. In other words, selling three personal computers produces more total margin (3 X $130 = $390) than selling one network server (1 X $240). Many factors could limit the sales of one or both of the products. Factors that limit a business’s ability to satisfy the demand for its product are called constraints. The computer that produces the highest contribution margin per unit of scarce resource (i.e., per square foot) is the more profitable product. When the size of the warehouse is limiting production, in business terms, the warehouse is considered to be a bottleneck. In other words, its size is limiting the company’s ability to produce and sell its products.

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. 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.

Fundamental Managerial Accounting Concepts

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Fundamental Managerial Accounting Concepts

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