Introduction to Management Accounting Relevant Information for Decision Making with a Focus on Operational Decisions Chapter 6
Opportunity, Outlay, and Differential Costs Incremental cost are additional costs or reduced benefits generated by the proposed alternative. Differential cost is the difference in total cost between two alternatives. Learning Objective 1 Differential revenue is the difference in total revenue between two alternatives. Incremental benefits are the additional revenues or reduced costs generated by the proposed alternative.
Opportunity, Outlay, and Differential Costs An outlay cost requires a cash disbursement. An opportunity cost is the maximum available contribution to profit forgone (or passed up) by using limited resources for a particular purpose. An incremental analysis is an analysis of the additional costs and benefits of a proposed alternative.
Opportunity, Outlay, and Differential Costs <ul><li>Nantucket Nectars has three alternatives: </li></ul><ul><li>Increase production of Peach juice </li></ul><ul><li>Sell the machine </li></ul><ul><li>3. Produce a new drink Papaya Mango </li></ul>Nantucket Nectars has a machine for which it paid $100,000 and it is sitting idle.
Opportunity Cost Sell machine for $50,000. 1 Peach Juice Contribution margin is $60,000. 2 3 Produce Papaya Mango juice with projected sales of $500,000. Revenue $500,000 Costs: Outlay Costs 400,000 Financial benefit before opportunity costs $100,000 Opportunity cost of machine 60,000 Net financial benefit $ 40,000
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. Learning Objective 2
Make or Buy Decisions Nantucket Nectars Company’s Cost of Making 12-ounce Bottles Direct material $ 60,000 $.06 Direct labor 20,000 .02 Variable factory overhead 40,000 .04 Fixed factory overhead 80,000 .08 Total costs $200,000 $.20
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?
Relevant Cost Comparison Purchase cost $180,000 $.18 Direct material $ 60,000 $.06 Direct labor 20,000 .02 Variable overhead 40,000 .04 Fixed OH avoided by not making 50,000 .05 0 0 Total relevant costs $170,000 $.17 $180,000 $.18 Difference in favor of making $ 10,000 $.01 Total Per Bottle Total Per Bottle Make Buy
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?
Make or Buy and the Use of Facilities Rent revenue $ — $ — $ 25 $ — Contribution from other products — — — 55 Variable cost of bottles (170) (180) (180) (180) Net relevant costs $(170) $(180) $(155) $(125) Make Buy and leave facilities idle Buy and rent out facilities Buy and use facilities for other products (000)
Avoidable and Unavoidable Costs 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. Learning Objective 3 Common costs are costs of facilities and services that are shared by users.
Department Store Example Groceries General merchandise Drugs Consider a discount department store that has three major departments:
Department Store Example Sales $1,900 $1,000 $800 $100 Variable expenses 1,420 800 560 60 Contribution margin $ 480 (25%) $ 200 (20%) $240 (30%) $ 40 (40%) Fixed expenses: Avoidable $ 265 $ 150 $100 $ 15 Unavoidable 180 60 100 20 Total fixed expenses $ 445 $ 210 $200 $ 35 Operating income $ 35$ (10) $ 40 $ 5 Departments Groceries General Mdse. Drugs Total ($000)
Department Store Example 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. Assume that the only alternatives to be considered are dropping or continuing the grocery department, which has consistently shown an operating loss.
Department Store Example Sales $1,900 $1,000 $900 Variable expenses 1,420 800 620 Contribution margin $ 480 $ 200 $280 Avoidable fixed expenses 265 150 115 Profit contribution to common space and other unavoidable costs $ 215 $ 50 $165 Unavoidable expenses 180 0 180 Operating income $ 35 $ 50 $ (15) Total Before Change Effect of Dropping Groceries Total After Change Store as a Whole ($000)
Department Store Example 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 $50,000, generate a 30% contribution-margin, and have avoidable fixed costs of $70,000. $80,000 – $50,000 = $30,000
Department Store Example Sales $1,900 $1,000 $500 $1,400 Variable expenses 1,420 800 350 970 Contribution margin $ 480 $ 200 $150 $ 430 Avoidable fixed expenses 265 150 70 185 Profit contribution to common space and other unavoidable costs $ 215 $ 50 $80 $245 Unavoidable expenses 180 0 0 180 Operating income $ 35 $ 50 $80 $ 65 Total Before Change Drop Groceries Total After Change Store as a Whole ($000) Expand General Merchandise
Optimal Use of Limited Resources Assume that the capacity of the facility is determined by machine time, and the maximum capacity is 10,000 machine hours. A limiting factor or scarce resource restricts or constrains the production or sale of a product or service. Learning Objective 4 The facility can produce 10 pairs of Air Court Shoes or 5 pairs of Air Max shoes per hour.
Optimal Use of Limited Resources Selling price per pair $80 $120 Variable costs per pair 60 84 Contribution margin per pair $20 $ 36 Contribution margin ratio 25% 30% Air Court Air Max
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?
Optimal Use of Limited Resources 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. Air Max is the product with the higher contribution per unit.
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?
Optimal Use of Limited Resources Air Court $20 contribution margin per pair × 10,000 hours = $2,000,000 contribution Air Max: $36 contribution margin per pair × 10,000 hours = $1,800,000 contribution
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).
Optimal Use of Limited Resources Regular Department Store Discount Department Store Faster inventory turnover makes the same product a more profitable use of space in a discount store. Retail Price $4.00 $3.50 Costs of Merchandise and other variable costs 3.00 3.00 Contribution to profit per unit $1.00 (25%) $ .50 (14%) Units sold per year 10,000 22,000 Total contribution to profit, assuming the same space allotment in both stores $10,000 11,000
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. Learning Objective 5
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?
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.
Joint Product Costs 1 million liters of X at a selling price of $.09 = $90,000 500,000 liters of Y at a selling price of $.06 = $30,000 Total sales value at split-off is $120,000 Joint-processing cost is $100,000 Split-off point
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.
Illustration of Sell or Process Further Revenues $30,000 $80,000 $50,000 Separable costs beyond split-off @ $.08 – 40,000 40,000 Income effects $30,000 $40,000 $10,000 Sell at Split-off as Y Process Further and Sell as YA Difference
Equipment Replacement The book value of equipment is not a relevant consideration in deciding whether to replace the equipment. Because it is a past, not a future cost. Why? Learning Objective 6
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.
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) 6,000 Book value $ 4,000
Keep or Replace the Old Machine? Original cost $10,000 $8,000 Useful life in years 10 4 Current age in years 6 0 Useful life remaining in years 4 4 Accumulated depreciation $ 6,000 0 Book value $ 4,000 N/A Disposal value (in cash) now $ 2,500 N/A Disposal value in 4 years 0 0 Annual cash operating costs $ 5,000 $3,000 Old Machine Replacement Machine
Relevance of Equipment Data 4 commonly encountered items: <ul><li>Book value of old equipment </li></ul><ul><li>Disposal value of old equipment </li></ul><ul><li>Gain or loss on disposal </li></ul><ul><li>Cost of new equipment </li></ul>A sunk cost is a cost already incurred and is irrelevant to the decision-making process.
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.
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.
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.
Cost of New Equipment The cost of new equipment is relevant because it is an expected future outflow that will differ among alternatives.
Cost Comparison Cash operating costs $20,000 $12,000 $8,000 Old equipment (book value): Depreciation, or 4,000 – – Lump-sum write-off – 4,000 – Disposal value – (2,500) 2,500 New machine acquisition cost – 8,000 (8,000) Total costs $24,000 $21,500 $2,500 Difference Keep Replace Four Years Together
Irrelevant or Misspecified Costs The ability to recognize irrelevant costs is important to decision makers. Cost of obsolete inventory Learning Objective 7 Book value of old equipment
Irrelevant or Misspecified Costs Suppose General Dynamics has 100 obsolete aircraft parts in its inventory. The original manufacturing cost of these parts was $100,000. General Dynamics can remachine the parts for $30,000 and then sell them for $50,000, or scrap them for $5,000.
Irrelevant or Misspecified Costs <ul><li>Expected future revenue $ 50,000 $ 5,000 $45,000 </li></ul><ul><li>Expected future costs 30,000 0 30,000 </li></ul><ul><li>Relevant excess of </li></ul><ul><li>revenue over costs $ 20,000 $ 5,000 $15,000 </li></ul><ul><li>Accumulated historical </li></ul><ul><li>inventory cost * 100,000 100,000 0 </li></ul><ul><li>Net loss on project $(80,000) $ (95,000) $15,000 </li></ul><ul><li>* Irrelevant because it is unaffected by the decision. </li></ul>Difference Remachine Scrap
Irrelevant or Misspecified Costs There are two major ways to go wrong when using unit costs in decision making: <ul><li>including irrelevant costs </li></ul><ul><li>comparing unit costs not computed </li></ul><ul><li>on the same volume basis </li></ul>
Irrelevant or Misspecified Costs Assume that a new $100,000 machine with a five-year life can produce 100,000 units a year at a variable cost of $1 per unit, as opposed to a variable cost per unit of $1.50 with an old machine. Is the new machine a worthwhile acquisition?
Irrelevant or Misspecified Costs Units 100,000 100,000 Variable cost $150,000 $100,000 Straight-line depreciation 0 20,000 Total relevant costs $ 45,000 $120,000 Unit relevant costs $ 1.50 $ 1.20 Old Machine New Machine
Irrelevant or Misspecified Costs It appears that the new machine will reduce costs by $.30 per unit. However, if the expected volume is only 30,000 units per year, the unit costs change in favor of the old machine.
Irrelevant or Misspecified Costs Units 30,000 30,000 Variable costs $45,000 $30,000 Straight-line depreciation 0 20,000 Total relevant costs $45,000 $50,000 Unit relevant costs $1.50 $1.6667 Old Machine New Machine
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. Learning Objective 8 Consider the replacement decision where replacing a machine has a $2,500 advantage over keeping it.
Decision Making and Performance Evaluation Cash operating costs $5,000 $3,000 $5,000 $3,000 Depreciation 1,000 2,000 1,000 2,000 Loss on disposal ($4,000 – $2,500) 0 $1,500 0 0 Total charges against revenue $6,000 $6,500 $6,000 $5,000 Keep Replace Keep Replace Year 1 Years 2, 3, and 4
Decision Making and Performance Evaluation 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. 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.