1. Topic 3 Relevant Costing and Contribution Analysis

2. Learning Objective 1 Use the seven-step decision process to make decisions.

3. Information and the Decision Process A decision model is a formal method for making a choice, often involving quantitative and qualitative analysis.

4. Seven-Step Decision Process identify objectives Search for alt. course of action Gather data on alternatives Implement the Decision Compare actual vs planned outcomes Step 1. Step 2. Step 3. Step 5. Step 6. Make Specific Predictions Feedback Step 7. Respond to divergences from plan Step 4.Select alt. course of action Historical Costs Other Information

5. Learning Objective 2 Differentiate relevant from irrelevant costs and revenues in decision situations.

6. The Meaning of Relevance Relevant costs and relevant revenues are expected future costs and revenues that differ among alternative courses of action. Historical costs Sunk costs Differential incomeDifferential costs

7. Learning Objective 3 Distinguish between quantitative and qualitative factors in decisions.

8. Quantitative and Qualitative Relevant Information Quantitative factors FinancialNonfinancial Qualitative factors

9. Quantitative and Qualitative Relevant Information Generally, relevant-cost analysis emphasises quantitative factors that can be expressed financially. But qualitative and quantitative non-financial factors are also important, and managers must at times give more weight to these factors.

10. Quantitative and Qualitative Relevant Information Key features of relevant information: Past (historical) costs may be helpful as basis for making predictions, but, in themselves are always irrelevant when making decisions. Different alternatives can be compared in examining differences in expected total future revenues and costs. Not all expected future revenues and costs are relevant. Those that do not differ among alternatives are irrelevant, hence can be eliminated from the analysis (key question is always: what difference will an action make?). Appropriate weight must be given to qualitative and quantitative non-financial factors.

11. Example: One-Time-Only Special Order The Bismark Co. manufacturing plant has a production capacity of 44,000 towels each month. Current monthly production is 30,000 towels. Costs can be classified as either variable or fixed with respect to units of output. Relevance: Choosing output levels

12. One-Time-Only Special Order Example Variable costs per unit Fixed costs per unit Direct materialsTShs. 6.50TShs. - 0 - Direct labour0.501.50 Manufacturing costs 1.50 3.50 TotalTShs. 8.50TShs. 5.00

13. One-Time-Only Special Order Example Total fixed direct manufacturing labour is TShs. 45,000. Total fixed overhead is TShs. 105,000. Marketing costs per unit are TShs. 7 (TShs. 5 of which is variable). What is the full cost per towel?

14. One-Time-Only Special Order Example A hotel in San Juan has offered to buy 5,000 towels from Bismark Co. at TShs. 11.50 per towel for a total of TShs. 57,500. No marketing costs will be incurred. Variable (TShs. 8.50 + TShs. 5.00):TShs. 13.50 Fixed: 7.00 Total (full cost)TShs. 20.50

15. One-Time-Only Special Order Example TShs. 8.50 × 5,000 = TShs. 42,500 incremental costs What are the incremental revenues ? What are the relevant costs of making the towels ? TShs. 57,500 – TShs. 42,500 = TShs. 15,000

16. Learning Objective 4 Beware of two potential problems in relevant-cost analysis.

17. Two Potential Problems in Relevant-Cost Analysis Incorrect general assumptions: All variable costs are relevant. All fixed costs are irrelevant. 12 Misleading unit-cost data: Include irrelevant costs. Use same unit costs at different output levels.

18. Outsourcing versus Insourcing Outsourcing is purchasing goods and services from outside suppliers. Insourcing is producing goods or providing services within the organisation.

19. Make-or-Buy Decisions Example Bismark Co. also manufactures bath accessories. Management is considering producing a part it needs (#2) or buying a part produced by Towson Co. for TShs. 0.55.

20. Make-or-Buy Decisions Example Bismark Co. has the following costs for 150,000 units of Part #2: Direct materialsTShs. 28,000 Direct labour 18,500 Mixed overhead 29,000 Variable overhead 15,000 Fixed overhead 30,000 TotalTShs. 120,500

21. Make-or-Buy Decisions Example Mixed overhead consists of material handling and setup costs. Bismark Co. produces the 150,000 units in 100 batches of 1,500 units each. Total material handling and setup costs equal fixed costs of TShs. 9,000 plus variable costs of TShs. 200 per batch.

22. Make-or-Buy Decisions Example What is the cost per unit for Part #2? TShs. 120,500 ÷ 150,000 units = TShs. 0.8033/unit Should Bismark Co. manufacture the part or buy it from Towson Co.??

23. Make-or-Buy Decisions Example Bismark Co. anticipates that next year the 150,000 units of Part #2 expected to be sold will be manufactured in 150 batches of 1,000 units each.

24. Make-or-Buy Decisions Example Variable mixed costs per batch are expected to decrease to TShs. 100. Bismark Co. plans to continue to produce 150,000 next year at the same variable manufacturing costs per unit as this year. Fixed costs are expected to remain the same as this year.

25. Make-or-Buy Decisions Example What is the variable manufacturing cost per unit? TShs. 61,500 ÷ 150,000 = TShs. 0.41 per unit Direct materialTShs. 28,000 Direct labour 18,500 Variable overhead 15,000 TotalTShs. 61,500

26. Make-or-Buy Decisions Example Expected relevant cost to make Part #2: Cost to buy: (150,000 × TShs. 0.55) TShs. 82,500 ManufacturingTShs. 61,500 Material handling and setups 15,000* Total relevant cost to makeTShs. 76,500 *150 × TShs. 100 = TShs. 15,000 Bismark Co. will save TShs. 6,000 by making the part.

27. Make-or-Buy Decisions Example Now assume that the TShs. 9,000 in fixed clerical salaries to support material handling and setup will not be incurred if Part #2 is purchased from Towson Co. Should Bismark Co. buy the part or make the part?

28. Make-or-Buy Decisions Example Relevant cost to make: VariableTShs. 76,500 Fixed 9,000 TotalTShs. 85,500 Cost to buy:TShs. 82,500 By buying the part, Bismark would save: TShs. 3,000

29. Learning Objective 5 Explain the opportunity-cost concept and why it is used in decision making.

30. Opportunity Costs, Outsourcing, and Constraints Assume that if Bismark buys the part from Towson, it can use the facilities previously used to manufacture Part #2 to produce Part #3 for Krista Company. The expected additional future operating income is TShs. 18,000. What should Bismark Co. do?

31. Opportunity Costs, Outsourcing, and Constraints Bismark Co. has three options regarding Krista: 1. Make Part #2 and do not make Part #3. 2. Buy Part #2 and do not make Part #3. 3. Buy the part and use the facilities to produce Part #3.

32. Opportunity Costs, Outsourcing, and Constraints Expected cost of obtaining 150,000 parts: Buy Part #2 and do not make Part #3:TShs. 82,500 Buy Part #2 and make Part #3: TShs. 82,500 – TShs. 18,000 =TShs. 64,500 Make Part #2: TShs. 76,500

33. Opportunity Costs, Outsourcing, and Constraints Opportunity cost is the contribution to Income that is forgone (rejected) by not using a limited resource in its next-best alternative use.

34. Opportunity Costs, Outsourcing, and Constraints Assume that annual estimated Part #2 requirements for next year is 150,000. Cost per purchase order is TShs. 40. Cost per unit when each purchase is 1,500 units = TShs. 0.55. Cost per unit when each purchase is equal to or greater than 150,000 = TShs. 0.54.

35. Opportunity Costs, Outsourcing, and Constraints Average investment in inventory is either: (1,500 ×.55) ÷ 2 = TShs. 412.50 or (150,000 × TShs. 0.54) ÷ 2 = TShs. 40,500 Annual interest rate for investment in government bonds is 6%. TShs. 412.50 ×.06 = TShs. 24.75 TShs. 40,500 ×.06 = TShs. 2,430

36. Opportunity Costs, Outsourcing, and Constraints Option A: Make 100 purchases of 1,500 units: Purchase order costs: (100 × TShs. 40)TShs. 4,000.00 Purchase costs: (150,000 × TShs. 0.55)TShs. 82,500.00 Annual interest income:TShs. 24.75 Relevant costs:TShs. 86,524.75

37. Opportunity Costs, Outsourcing, and Constraints Option B: Make 1 purchase of 150,000 units: Purchase order costs: (1 × TShs. 40)TShs. 40 Purchase costs: (150,000 × TShs. 0.54)TShs. 81,000 Annual interest income:TShs. 2,430 Relevant costs:TShs. 83,470

38. Learning Objective 6 Know how to choose which products to produce when there are capacity constraints.

39. Product-Mix Decisions Under Capacity Constraints Per unit Product #2 Product #3 Sales priceTShs. 2.11TShs. 14.50 Variable expenses 0.41 13.90 Contribution marginTShs. 1.70TShs. 0.60 Contribution margin ratio 81% 4% Bismark Co. has 3,000 machine-hours available.

40. Product-Mix Decisions Under Capacity Constraints One unit of Prod. #2 requires 7 machine-hours. One unit of Prod. #3 requires 2 machine-hours. What is the contribution of each product per machine-hour? Product #2: TShs. 1.70 ÷ 7 = TShs. 0.24 Product #3: TShs. 0.60 ÷ 2 = TShs. 0.30

41. Learning Objective 7 Discuss what managers must consider when adding or discontinuing customers and segments.

42. Profitability, Activity-Based Costing, and Relevant Costs Mountain View Furniture supplies furniture to two local retailers – Stevens and Cohen. The company has a monthly capacity of 3,000 machine-hours. Fixed costs are allocated on the basis of revenues.

43. Profitability, Activity-Based Costing, and Relevant Costs Stevens Cohen RevenuesTShs. 200,000TShs. 100,000 Variable costs 70,000 60,000 Fixed costs 100,000 50,000 Total operating costsTShs. 170,000TShs. 110,000 Operating incomeTShs. 30,000TShs. (10,000) Machine-hours required 2,000 1,000

44. Profitability, Activity-Based Costing, and Relevant Costs Total RevenuesTShs. 300,000 Variable costs 130,000 Fixed costs 150,000 Total operating costsTShs. 280,000 Operating incomeTShs. 20,000 Machine-hours required 3,000

45. Profitability, Activity-Based Costing, and Relevant Costs Should Mountain View Furniture drop the Cohen business, assuming that dropping Cohen would decrease its total fixed costs by 10%? New fixed costs would be: TShs. 150,000 – TShs. 15,000 = TShs. 135,000

46. Profitability, Activity-Based Costing, and Relevant Costs Stevens Alone RevenuesTShs. 200,000 Variable costs 70,000 Fixed costs 135,000 Total operating costsTShs. 205,000 Operating incomeTShs. (5,000) Machine-hours required 3,000

47. Profitability, Activity-Based Costing, and Relevant Costs Cohen’s business is providing a contribution margin of TShs. 40,000. TShs. 40,000 decrease in contribution margin –TShs. 15,000 decrease in fixed costs =TShs. 25,000 decrease in operating income.

48. Profitability, Activity-Based Costing, and Relevant Costs Assume that if Mountain View Furniture drops Cohen’s business it can lease the excess capacity to the Perez Corporation for TShs. 70,000. Fixed costs would not decrease. Should Mountain View Furniture lease to Perez?

49. Profitability, Activity-Based Costing, and Relevant Costs Steven Perez Total Revenues200,00070,000270,000 Variable costs70,0000 Fixed costs135,0000 Total operating costs205,0000 Operating income(5,000)70,00065,000

50. Learning Objective 8 Explain why the book value of equipment is irrelevant in equipment-replacement decisions.

51. Equipment-Replacement Decisions Example Existing Replacement Machine Original costTShs. 80,000 TShs. 105,000 Useful life4 years 4 years Accumulated depreciationTShs. 50,000 Book valueTShs. 30,000 Disposal priceTShs. 14,000 Annual costsTShs. 46,000 TShs. 10,000

52. Equipment-Replacement Decisions Example Ignoring the time value of money and income taxes, should the company replace the existing machine? The cost savings over a 4-year period will be TShs. 36,000 × 4 = TShs. 144,000. Investment = TShs. 105,000 – TShs. 14,000 = TShs. 91,000 TShs. 144,000 – TShs. 91,000 = TShs. 53,000 advantage of the replacement machine.

53. Learning Objective 9 Explain how conflicts can arise between the decision model used by a manager and the performance evaluation model used to evaluate the manager.

54. Decisions and Performance Evaluation What is the journal entry to sell the existing machine? Cash14,000 Accumulated Depreciation50,000 Loss on Disposal16,000 Machine80,000

55. Decisions and Performance Evaluation In the real world would the manager replace the machine? An important factor in replacement decisions is the manager’s perceptions of whether the decision model is consistent with how the manager’s performance is judged.

56. Decisions and Performance Evaluation Top management faces a challenge – that is, making sure that the performance-evaluation model of subordinate managers is consistent with the decision model.