1. Chapter 6 Relevant Information and Decision- Making: Production Decisions

2. Objective 1 Define Opportunity Cost and Use it to Analyze the Income Effects of a Given Alternative

3. Opportunity, Outlays and Differential Costs
Opportunity cost
is the maximum available contribution to profit forgone (or passed up ) by using limited resources for a particular purpose.
This definition indicates that opportunity cost is not the usual outlay cost recorded in accounting. Opportunity cost is the contribution of the best alternative that is excluded .

4. Outlay cost Differential cost
A cost that requires a cash disbursement. Outlay cost is the typical cost recorded by account .
Differential cost
Or incremental cost is the difference in total cost between two alternatives .

5. Opportunity Cost
The contribution to profit of best of the rejected alternatives. ( contribution of the best alternative is excluded from consideration.)
An example
The salary forgone by a person who quits a job to start a business.

6. Alternatives under Consideration
Difference
Open
a new
business
Remain as
employee
140,000
200,000
60,000
Revenues
120,000 -
Outlay costs
20,000
80,000
Income effect per year
The opportunity cost of the new business is 60,000 the forgone annual salary.
Alternative chosen:
New business
200,000
Revenues
Expenses:
120,000
Outlay costs
60,000
Opportunity cost of employee salary
180,000
20,000
Income effect per year

7. The first solution (tabulation) does not mention opportunity cost because the economic impacts are individually measured for each of the alternatives. Neither alternative has been excluded from consideration
The second mention opportunity cost ( salary, impact of the best excluded alternative) as a cost of the chosen alternative
The failure to recognize opportunity cost in the second tabulation wile misstate the difference between alternatives.

8. If the first alternatives is chosen
Alternative chosen:
Remain as employee
60,000
Revenues
Expenses: -
Outlay costs
80,000
Opportunity cost of independent practice
(20,000)
Income effect per year

9. Objective 2 Analyze Given Data to Support a Decision to Make or Buy Certain Parts or Products

10. Make or Buy and Idle Facilities
Companies often must decide whether to produce its own parts and subassemblies or buy them from an outside supplier.
Sometimes quantitative factors dominate qualitative assessments of costs. Some manufactures always make parts because they want to control quality, others because they possess special know-how, usually skilled labor or rare raw materials needed for production. Alternatively, some companies always purchase parts to protect mutually advantageous long-run relationships with their suppliers.

11. What quantitative factors are relevant to the decision to make or buy ?
A key Factor is whether there are idle facilities.
The key to make-or-buy decisions is identifying the additional costs for making ( or the costs avoided by buying ) a part or subcomponent.
The relevant costs to this decision include the additional variable costs, and the fixed costs that will be eliminated if the parts are bought instead of made

12. Buy Make Per unit Total 10 200,000 Purchase cost : 1 20,000
Direct material 4
80,000
Direct labor 2
40,000
Variable factory overhead
Fixed factory overhead that can be avoided by not making (supervisor’s salary) 8
160,000
Total relevant costs
Difference in favor of making

13. Make or Buy : Use of Facilities
The choice in make- or- buy decisions is not only whether to make or buy, it is how best to use available facilities.
Suppose the released facilities can be used in some other manufacturing activity ( to produce a contribution to profits of, say, L.E ) or can be rented out (say, for L.E ).

14. The alternatives are: Make the parts.
Buy the part and leave facilities idle.
Buy and rent out facilities.
Buy and use facilities for other products.
Buy &use facilities for other product
Buy &rent out facilities
Buy & leave facilities idle
Make - 35
Rent revenue 55
Contribution from other products
(200)
(160)
Obtaining of parts
(145)
(165)
Net relevant costs

15. Electrical and Mechanical Components
Example
Industrial
Drills
Plastic
Housing
Electrical and Mechanical Components
10,000,000
Revenue100,000 L.E. 100
Variable costs :
4,900,000
500,000
4,400,000
Direct material
700,000
300,000
400,000
Direct labor
200,000
100,000
Variable factory overhead -
Other variable costs
1,000,000
Sales 10% of sales
7,000,000
6,000,000
Total variable costs
3,000,000
Contribution margin
2,300,000
1,900,000
Reparable fixed costs
80,000
320,000
Common fixed costs
2,700,000
480,000
2,220,000
Total fixed costs
Operating income

16. Required
During the year a prospective customer in an unrelated market offered L.E for 1,000 drills. The latter would be in addition to the 100,000 units sold. The regular sales commission rate would have been paid. The president rejected the order because " it was below cur costs of L.E. 97 per unit " What would operating income have been if the order had been accepted? 1
A supplier offered to manufacture the year's supply of 100,000 plastic housings for L.E each. What would be the effect on operating income if the Block Company purchased rather than made the housings? Assume that L.E.350,000 of the separable fixed costs assigned to housings would have been avoided if the housings were purchased. 2

17. 3
The company could have purchased the housings for L.E each and used the vacated space for the manufacture of a deluxe version of its drill. Assume that 20,000 deluxe units could have been made ( and sold in addition to the 100,000 regular units) at a unit variable cost of L.E.90, exclusive of housings and exclusive of the 10% sales commission. The 20,000 extra plastic housings could also be purchased for L.E each. The sales price would have continued, because these costs related primarily to the manufacturing facilities used. What would operating income have been if Block had bought the housings and made and sold the deluxe units?

18. The costs of filling the special order follow:
Solution
The costs of filling the special order follow: 1
49,000
Direct material
7,000
Direct labor
3,000
Variable factory overhead
1,000
Other variable costs
8,200
Sales 10% of sales × 82,000
68,200
Total variable costs
82,000
Selling price
13,800
Contribution margin
Operating income would have been L.E L.E or L.E , if the order had been accepted. In a sense, the decision to reject the offer implies that the Block Company is willing to invest L.E in immediate gains forgone (an opportunity cost ) in order to preserve the long – run selling- price structure.

19. Assuming that L.E of the fixed costs could have been avoided by not making the housings and that the other fixed costs would have been continued, the alternatives can be summarized as follows: 2
Buy
Make
1,350,000
Purchase cost
1,000,000
Variable costs
350,000
Avoidable fixed costs
Total relevant costs
If the facilities used for plastic housings became idle, the Block Company would be indifferent as to whether to make or buy. Operating income would be unaffected.

20. The effect of purchasing the plastic housings and using the vacated facilities for manufacture of a deluxe version of its drill is: 3
2,600,000
Sales would increase by 20,000 L.E. 130
1,800,000
Variable costs exclusive of parts would increase by 20,000 L.E. 90
2.060,000
260,000
Plus: sales commission, 10% of L.E. 2, 600,000
540,000
Contribution margin on 20,000 units
Housing: 120,000 rather than 100,000 would be Needed
1,620,000
Buy L.E
1,000,000
Make L.E. 10 (only the variable costs Are relevant)
620,000
Excess cost of outside purchase -
Fixed costs, unchanged
80,000
Disadvantage of making deluxe units

21. Operating income would decline to L. E. 220,000 (L. E. 300,000 - L. E
Operating income would decline to L.E. 220,000 (L.E.300,000 - L.E. 80,000). The deluxe un bring in a contribution margin of L.E. 540,000, but the additional costs of buying rather than making housings is L.E. 620,000, leading to a net disadvantage of L.E. 80,000.

22. Thank you