1. Introduction to Management Accounting
Chapter 6
Relevant Information for
Decision Making with a Focus
on Operational Decisions

2. Make-or-Buy Decisions
Case 1
Make-or-Buy Decisions
Managers often must decide whether to
produce a product or service within the
firm or purchase it from an outside supplier.

3. Make or Buy Decisions
Direct material $ 60, $.06
Direct labor ,
Variable factory overhead 40,
Fixed factory overhead ,
Total costs $200, $.20
Nantucket Nectars Company’s Cost of Making 12-ounce Bottles

4. Make-or-Buy Example Another manufacturer offers to sell
Nantucket the bottles for $.18.
If the company buys the bottles, $50,000
of fixed overhead would be eliminated.
Should Nantucket make or buy the bottles?

5. Relevant Cost Comparison
Purchase cost $180,000 $.18
Direct material $ 60,000 $.06
Direct labor ,
Variable overhead ,
Fixed OH avoided by
not making ,
Total relevant costs $170,000 $ $180,000 $.18
Difference in favor
of making $ 10,000 $.01
Total
Per Bottle
Make
Buy

6. Make or Buy and the Use of Facilities
Suppose Nantucket can use the released
facilities in other manufacturing activities
to produce a contribution to profits of
$55,000, or can rent them out for $25,000.
What are the alternatives?

7. Make or Buy and the Use of Facilities
(000)
Buy and
rent out
facilities
Make
Buy and
leave
facilities
idle
Buy and use
facilities
for other
products
Rent revenue $ — $ — $ $ —
Contribution from
other products — — —
Variable cost of bottles (170) (180) (180) (180)
Net relevant costs $(170) $(180) $(155) $(125)

8. Deletion or Addition of Products, Service, or Departments
Case 2
Deletion or Addition of Products, Service, or Departments
Avoidable costs are costs that will
not continue if an ongoing
operation is changed or deleted.
Unavoidable costs are costs that
continue even if an operation is halted.
Common costs are costs of facilities and
services that are shared by users.

9. Department Store Example
Consider a discount department store
that has three major departments:
Groceries
General merchandise
Drugs

10. Department Store Example
Total
Groceries
General
Mdse.
Drugs
Sales $1, $1, $ $100
Variable expenses 1,
Contribution margin $ (25%) $ (20%) $240 (30%) $ 40 (40%)
Fixed expenses:
Avoidable $ $ $ $ 15
Unavoidable
Total fixed expenses $ $ $ $ 35
Operating income $ $ (10) $ $ 5
($000)

11. Department Store Example
Assume that the only alternatives to be considered
are dropping or continuing the grocery department,
which has consistently shown an operating loss.
Assume further that the total assets invested
would be unaffected by the decision.
The vacated space would be idle and
the unavoidable costs would continue.

12. Department Store Example
Store as a Whole ($000)
Total
Before
Change
Effect of
Dropping
Groceries
Total
After
Change
Sales $1,900 $1,000 $900
Variable expenses ,
Contribution margin $ $ $280
Avoidable fixed expenses
Profit contribution to
common space and
other unavoidable costs $ $ $165
Unavoidable expenses
Operating income $ $ $ (15)

13. Department Store Example
Assume that the store could use the space
made available by the dropping of groceries
to expand the general merchandise department.
Assume that the store could use the space
made available by the dropping of groceries
to expand the general merchandise department.
This will increase sales by $500,000,
generate a 30% contribution-margin,
and have avoidable fixed costs of $70,000

14. Department Store Example
Store as a Whole ($000)
Total
Before
Change
Drop
Groceries
Expand
General
Merchandise
Total
After
Change
Sales $1,900 $1,000 $ $1,400
Variable expenses 1,
Contribution margin $ $ $ $ 430
Avoidable fixed expenses
Profit contribution to
common space and
other unavoidable costs $ $ $ $245
Unavoidable expenses
Operating income $ $ $ $ 65

15. Optimal Use of Limited Resources
Case 3
Optimal Use of Limited Resources
A limiting factor or scarce resource
restricts or constrains the production
or sale of a product or service.
Assume that the capacity of the facility is
determined by machine time, and the
maximum capacity is 10,000 machine hours
The facility can produce 10 pairs of Air Court
Shoes or 5 pairs of Air Max shoes per hour.

16. Optimal Use of Limited Resources
Selling price per pair $ $120
Variable costs per pair
Contribution margin per pair $ $ 36
Contribution margin ratio % 30%
Air
Court
Max

17. Optimal Use of Limited Resources
Which is more profitable?
If the limiting factor is demand, that is, pairs
of shoes, the more profitable product is Air Max.
Why?

18. Optimal Use of Limited Resources
Air Max is the product with
the higher contribution per unit.
The sale of a pair of Air Court
shoes adds $20 to profit.
The sale of a pair of Air Max
shoes adds $36 to profit.

19. Optimal Use of Limited Resources
Suppose that demand for either shoe would fill the
plant’s capacity. Now, capacity is the limiting factor.
Which is more profitable?
If the limiting factor is capacity,
the more profitable product is Air Court.
Why?

20. Optimal Use of Limited Resources
Air Court
$20 contribution margin per pair × 100,000 pairs
= $2,000,000 contribution
Air Max:
$36 contribution margin per pair × 50,000 pairs
= $1,800,000 contribution

21. Optimal Use of Limited Resources
In retails stores, the limiting factor is often floor space.
The focus is on products taking up less space or
on using the space for shorter periods of time.
Retail stores seek faster inventory turnover
(the number of times the average
inventory is sold per year).

22. Optimal Use of Limited Resources
Faster inventory turnover makes the same product
a more profitable use of space in a discount store.
Retail Price $ $3.50
Costs of Merchandise and other variable costs
Contribution to profit per unit $1.00 (25%) $ .50 (14%)
Units sold per year , ,000
Total contribution to profit, assuming the
same space allotment in both stores $10, ,000
Regular
Department
Store
Discount
Department
Store

23. Case 4
Joint Product Costs
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.

24. Joint Product Costs Separable costs are any costs
beyond the split-off point.
Joint costs are the costs of manufacturing
joint products before the split-off point.
Should Dow sell the products at the
split-off point or process them further?

25. Joint Product 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.

26. Joint Product Costs Joint-processing cost is $100,000
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
Split-off point
Total sales value at
split-off is $120,000

27. 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.

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

29. Equipment Replacement
Case 5
Equipment Replacement

30. 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.

31. Book Value of Old Equipment
Suppose a $10,000 machine with a 10-year life
span 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) ,000
Book value $ 4,000

32. Keep or Replace the Old 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
Old
Machine
Replacement

33. Cost Comparison 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 – , (8,000)
Total costs $24,000 $21, $2,500
Difference
Keep
Replace
Four Years Together

34. Relevance of Equipment Data
A sunk cost is a cost already incurred and is
irrelevant to the decision-making process.
4 commonly encountered items:
Book value of old equipment
Disposal value of old equipment
Gain or loss on disposal
Cost of new equipment

35. Relevance of Equipment Data
The book value of old equipment is irrelevant
because it is a past (historical) cost.
Therefore, depreciation on
old equipment is irrelevant.

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

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

38. Cost of New Equipment The cost of new equipment is relevant
because it is an expected future outflow
that will differ among alternatives.

39. Decision Making and Performance Evaluation
Case 6
Decision Making and Performance Evaluation
To motivate managers to make the right choice,
the method used to evaluate performance should
be consistent with the decision model.
Consider the replacement decision where replacing a
machine has a $2,500 advantage over keeping it.

40. Decision Making and Performance Evaluation
Year 1
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

41. Decision Making and Performance Evaluation
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.
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.