Chapter 5 Relevant Information for Special Decisions

Davis Driveways, Inc.Cost Plus Pricing Policy

Materials $100Labor 120Overhead* 80Total $300Desired Profit 50Price $350

*Annual overhead cost for rent on the corporate office and supervisory salaries is $80,000. Normal volume is 1,000 driveways per year. Overhead cost per unit is determined as $80,000 / 1,000 units = $80 per unit. The relevant range is from 800 to 1,500 units.

A new builder offers to purchase 200 driveways from DDI. She is only willing to pay $250 per driveway.

Should DDI accept this offer?

Chapter 5

Relevant Information forSpecial Decisions

Relevant Information

Two primary characteristics Two primary characteristics distinguish relevant from useless distinguish relevant from useless

information:information:

1.1. Relevant information Relevant information differs differs among among the alternatives under consideration.the alternatives under consideration.

2.2. Relevant information is future Relevant information is future oriented.oriented.

Two primary characteristics Two primary characteristics distinguish relevant from useless distinguish relevant from useless

information:information:

1.1. Relevant information Relevant information differs differs among among the alternatives under consideration.the alternatives under consideration.

2.2. Relevant information is future Relevant information is future oriented.oriented.

Relevant (Differential) Revenues

Relevant revenues must (1) be future oriented and (2) differ for the

alternatives under consideration. Since relevant revenues differ between the

alternative, they are sometimes called differential revenues.

• Pass Fast, Inc. is considering two alternative locations in which to conduct its CPA review course. One alternative is an exclusive hotel; the other is a moderately priced training facility. The hotel is in a central location easily accessible to potential students. The training facility is in a less desirable location. Pass Fast has gathered the following cost data regarding the two locations.

RELEVANT INFORMATION

Rental Fee for Classroom $2,000 $1,500

Twenty Advertising Brochures Distributed to each Student for Referrals

250 250

Cost of Instruction 5,000 5,000

Books (per student) 100 100

Refreshments (per student) 5 4

Depreciation on Instructional Equipment 400 400

Sunk Cost

A sunk cost has been incurred in the a past transaction and cannot be changed, they are not

relevant for making current decisions.

Relevancy of Opportunity Costs

The sacrifice represented by a lost opportunity is an opportunity cost.

Opportunity costs that are (1) future oriented and (2) differ between the alternatives are relevant

for decision making, but are extremely difficult to measure.

Let’s look at an example.

Opportunity Cost• You purchased a ticket to the Texas Tech – UT game this fall for

$80.• Outside the game someone offers you $150.• You really want to go to the game and don’t sell your ticket• How much did it cost you to go to the game?• $150 is your opportunity cost• $80 is your sunk cost

Example• Brown Manufacturing Company is

currently using a building as a manufacturing facility. Depreciation on the building is $200,000 per year. The building is in a location that is experiencing significant growth in retail shopping. A retail company has offered to rent the manufacturing facility from BMC at a price of $180,000 per year.

• What information is relevant in deciding whether to move the manufacturing facility to a different location?

Relevant (Avoidable) Costs

Unit-levelUnit-levelActivitiesActivities

Batch-levelBatch-levelActivitiesActivities

Product-levelProduct-levelActivitiesActivities

Facility-levelFacility-levelActivitiesActivities

Avoided by eliminating oneAvoided by eliminating oneunit of product.unit of product.

Avoided when a batch ofAvoided when a batch ofwork is eliminated.work is eliminated.

Avoided if a product lineAvoided if a product lineis eliminated.is eliminated.

Some costs may be avoidedSome costs may be avoidedif a product line is eliminated.if a product line is eliminated.

Cost Classification Hierarchy

• Unit-level Costs– Incurred each time a company generates one unit of product– Example: Direct materials & direct labor costs

• Batch-level Costs– Costs incurred for a batch of products– Example: Setup and inspection costs

• Product-level Costs– Costs incurred to create, sustain, or sell a product or product

line– Example: Engineering costs for new automobile model

• Facility-level Costs– Incurred to support the entire company– Example: Factory depreciation; maintenance; utilities

Four Types of Special DecisionsSpecial Order

Outsourcing

Segment Elimination

Asset Replacement

Relevant Information and Special Decisions

Occasionally, a company receives an offer to sell Occasionally, a company receives an offer to sell its product at a price significantly below its normal its product at a price significantly below its normal selling price. The company must make a selling price. The company must make a special special

order decisionorder decision to accept or reject the offer. to accept or reject the offer.

Occasionally, a company receives an offer to sell Occasionally, a company receives an offer to sell its product at a price significantly below its normal its product at a price significantly below its normal selling price. The company must make a selling price. The company must make a special special

order decisionorder decision to accept or reject the offer. to accept or reject the offer.

Unit-level costs Materials costs (2,000 × $90) 180,000$ Labor costs (2,000 × $82.50) 165,000 Overhead (2,000 × $7.50) 15,000 Total unit-level costs 360,000$ Batch-level costs Assembly setup (10 × $1,700) 17,000 Materials handling (10 × $500) 5,000 Total batch-level costs 22,000 Product-level costs Engineering design 14,000 Production manager's salary 63,300 Total product-level costs 77,300 Facility-level costs Segement-level costs 85,000 Division manager's salary 12,700 Company president's salary 43,200 Depreciation 27,300 General expenses 31,000 Total facility-level costs 199,200 Total expected costs 658,500$

Budgeted Cost for Expected Production of 2,000 Printers

Cost per unit - $658,500 ÷ 2000 = $329.25$329.25

Here is budgeted Here is budgeted cost information cost information

for Premier, a for Premier, a company that company that

produces produces printers. The printers. The company has company has

enough capacity enough capacity to produce to produce additional additional

printers, but is printers, but is planning to planning to

produce to meet produce to meet current demand.current demand.

Here is budgeted Here is budgeted cost information cost information

for Premier, a for Premier, a company that company that

produces produces printers. The printers. The company has company has

enough capacity enough capacity to produce to produce additional additional

printers, but is printers, but is planning to planning to

produce to meet produce to meet current demand.current demand.

Special Order Decision

A foreign customer offers to purchase 200 printers at $250 per printer. This price is well below the

unit cost of $329.25. Should the company accept this one time order?

Differential revenue ($250 ×200) 50,000$ Avoidable unit-level costs ($180 × 200) (36,000) Avoidable batch-level costs: Assembly setup (1,700) Materials handling (500) Contribution to income 11,800$

Relevant Information for Special Order

If the order is accepted, income will increase by If the order is accepted, income will increase by $11,800.$11,800.


If Premier can increase income by selling its printer for $250, can the company reduce its

normal selling price to $250?

Revenue ($250 × 2,200) 550,000$ Unit-level costs ($180 × 2,200) 396,000$ Batch-level costs (11 × $2,200) 24,200 Production-level costs 77,300 Facility-level costs 199,200 Total cost 696,700 Projected loss (146,700)$

Selling 2,200 Printers for $250 Per Unit


• Quantitative Aspect

1. Determine the amount of revenue the company will earn if it accepts the special order

2. Determine the relevant costs of making the additional units

3. Compare the incremental revenues to the additional costs

What costs must be considered?

• Unit-level costs– Relevant b/c cost will differ if the company

makes and sells the units vs. rejecting the special order

• Batch-level costs– May or may not be relevant– Relevant if must produce a separate batch to

fill the order

• Product-level and Facility-level costs remain unchanged = Not Relevant

Outsourcing Decisions

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 outsourcingoutsourcing.

That test was so That test was so easy. How did you easy. How did you

score so low?score so low?

That test was so That test was so easy. How did you easy. How did you

score so low?score so low?

I outsourced I outsourced my homework!!my homework!!

I outsourced I outsourced my homework!!my homework!!


Let’s return to our Premier example. Recall that the unit cost per printer was $329.25. A supplier offers to sell an unlimited number of printers to

Premier for $240 each. Should Premier accept this outsourcing offer?

Step 1Step 1Determine the production costs Premier can avoid if itDetermine the production costs Premier can avoid if itelects to outsource printer production.elects to outsource printer production.

Step 1Step 1Determine the production costs Premier can avoid if itDetermine the production costs Premier can avoid if itelects to outsource printer production.elects to outsource printer production.

Unit-level costs ($180 × 2,000) 360,000$ Batch-level costs (10 × $2,200) 22,000 Product-level costs 77,300 Total relevant cost 459,300$

Relevent Costs for 2,000 Printers

Cost per unit = $459,300 Cost per unit = $459,300 ÷ 2,000 = $229.65÷ 2,000 = $229.65Cost per unit = $459,300 Cost per unit = $459,300 ÷ 2,000 = $229.65÷ 2,000 = $229.65


Step 2Step 2Compare the avoidable production costs with the cost ofCompare the avoidable production costs with the cost ofbuying the product and select the lower-cost option.buying the product and select the lower-cost option.

Step 2Step 2Compare the avoidable production costs with the cost ofCompare the avoidable production costs with the cost ofbuying the product and select the lower-cost option.buying the product and select the lower-cost option.

Premier should reject the outsourcing offer.

COST TO BUY:

$240 * 2,200 = $528,000

COST TO MAKE:

$459,300


• Must identify the relevant costs of making a product internally and compare with cost to buy the product from an outside supplier

• Make or buy decision

• Relevant Costs:– Unit-level costs– Batch-level costs– Product-level costs

• Facility-level costs = Not relevant

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 an a segment

report for Premier Office Products that has divided its operations into three segments; (1) copiers, (2)

computers, and (3) printers.

Copiers Computers Printers TotalProjected revenue 550,000$ 850,000$ 780,000$ 2,180,000$ 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 (15,000) (26,000) (17,000) (58,000) Materials handling (6,000) (8,000) (5,000) (19,000) Product-level costs Engineering costs (10,000) (12,000) (14,000) (36,000) Production manager salary (52,000) (55,800) (63,300) (171,100) 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 expenses (31,000) (31,000) (31,000) (93,000) Projected profit (loss) (22,250)$ 136,250$ 121,500$ 235,500$

Should management eliminate the Copier segment?


A three part decision:A three part decision:

1.1. Determine the amount of relevant Determine the amount of relevant revenue that pertains to eliminating the revenue that pertains to eliminating the segment.segment.

2.2. Determine the amount of cost that can Determine the amount of cost that can be avoided if the segment is eliminated.be avoided if the segment is eliminated.

3.3. If the relevant revenue is less than the If the relevant revenue is less than the avoidable cost, eliminate the segment. If avoidable cost, eliminate the segment. If not, continue to operate it.not, continue to operate it.


Step 1:Step 1:If Premier eliminates the copier If Premier eliminates the copier segment, it will lose the $550,000 of segment, it will lose the $550,000 of revenue currently produced. If the revenue currently produced. If the segment continues, the revenue will be segment continues, the revenue will be earned. Since the revenue differs earned. Since the revenue differs between the alternatives, between the alternatives, it is relevantit is relevant..

Step 1:Step 1:If Premier eliminates the copier If Premier eliminates the copier segment, it will lose the $550,000 of segment, it will lose the $550,000 of revenue currently produced. If the revenue currently produced. If the segment continues, the revenue will be segment continues, the revenue will be earned. Since the revenue differs earned. Since the revenue differs between the alternatives, between the alternatives, it is relevantit is relevant..


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)$

Step 2:Step 2:If Premier eliminates copiers, it will avoid the If Premier eliminates copiers, it will avoid the following costs:following costs:

Step 2:Step 2:If Premier eliminates copiers, it will avoid the If Premier eliminates copiers, it will avoid the following costs:following costs:


Step 2:Step 2:If Premier eliminates copiers, its profits If Premier eliminates copiers, its profits will decrease:will decrease:

Step 2:Step 2:If Premier eliminates copiers, its profits If Premier eliminates copiers, its profits will decrease:will decrease:

Revenue lost 550,000$ Costs avoided (488,000) Decrease in profit 62,000$

The corporate-level facility-sustaining costs The corporate-level facility-sustaining costs will not be eliminated, but will be allocated to will not be eliminated, but will be allocated to

the remaining segments.the remaining segments.

Computers Printers TotalProjected revenue 850,000$ 780,000$ 1,630,000$ Projected costs

Unit-level costs Materials costs (178,000) (180,000) (358,000) Labor costs (202,000) (165,000) (367,000) Overhead (20,000) (15,000) (35,000) Batch-level costs Assembly setup (26,000) (17,000) (43,000) Materials handling (8,000) (5,000) (13,000) Product-level costs Engineering costs (12,000) (14,000) (26,000) Production manager salary (55,800) (63,300) (119,100) Facility-level costs Segment level Division manager salary (92,000) (85,000) (177,000) Administrative costs (13,200) (12,700) (25,900) Allocated-corporate level Company president salary (63,000) (60,200) (123,200) Building rental (39,375) (36,925) (76,300) General expenses (46,500) (46,500) (93,000) Projected profit (loss) 94,125$ 79,375$ 173,500$

Assuming we eliminate the copier segment and allocate the corporate-level costs to the remaining two divisions equally, the company’s income statement will look like this.

Profits before elimination 235,500$ Profits after elimination 173,500 Decrease in profit 62,000$

Segment Elimination Decisions• Identify relevant costs of operating a business

segment and compare with cost to revenue generated by the segment

• Choice: Close-down or Continue Segment• Relevant Costs:

– Unit-level costs– Batch-level costs– Product-level costs– Facility-level costs

• Some Corporate-level facility costs may not be relevant

Relationships Between Avoidable Costs and Business Activity

1.1. Special order decisions affect unit-level and Special order decisions affect unit-level and possibly batch-level costs.possibly batch-level costs.

2.2. Outsourcing can avoid many product-level as Outsourcing can avoid many product-level as well as unit- and batch-level costs.well as unit- and batch-level costs.

3.3. Segment elimination can avoid some of the Segment elimination can avoid some of the facility-level costs.facility-level costs.

1.1. Special order decisions affect unit-level and Special order decisions affect unit-level and possibly batch-level costs.possibly batch-level costs.

2.2. Outsourcing can avoid many product-level as Outsourcing can avoid many product-level as well as unit- and batch-level costs.well as unit- and batch-level costs.

3.3. Segment elimination can avoid some of the Segment elimination can avoid some of the facility-level costs.facility-level costs.

The more complex the decision level, the The more complex the decision level, the more opportunities there are to avoid more opportunities there are to avoid

costs.costs.

Equipment Replacement Decision

The equipment replacement decision should be based on profitability rather than physical deterioration. Consider the following:

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

Cost 29,000$ Salvage value (in 5 years) 4,000 Operating expenses ($4,500 × 5 years) 22,500

Old Machine

New Machine


1.1. The original cost, current book value, accumulated The original cost, current book value, accumulated depreciation, and annual depreciation expense are depreciation, and annual depreciation expense are measures of cost of the old machine relating to measures of cost of the old machine relating to prior periods. They are irrelevant because they are prior periods. They are irrelevant because they are sunk costs.sunk costs.

2.2. The $14,000 market value of the old machine is an The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement opportunity cost and is relevant to the replacement decision.decision.

3.3. The salvage value of the old machine reduces the The salvage value of the old machine reduces the opportunity cost. The opportunity cost of using the opportunity cost. The opportunity cost of using the old machine for five more years is $12,000 old machine for five more years is $12,000 ($14,000 ($14,000 – $2,000).– $2,000).

4.4. The $45,000 operating expenses of using the old The $45,000 operating expenses of using the old machine can be avoided if it is replaced, to it is a machine can be avoided if it is replaced, to it is a relevant cost.relevant cost.


1.1. The cost of the new machine can be avoided The cost of the new machine can be avoided by keeping the old machine, so it is a by keeping the old machine, so it is a relevant cost.relevant cost.

2.2. The relevant cost of purchasing the new The relevant cost of purchasing the new machine is $25,000 ($29,000 machine is $25,000 ($29,000 – $4,000)– $4,000)..

3.3. The $22,500 of operating expenses can be The $22,500 of operating expenses can be avoided by keeping the old machine, so the avoided by keeping the old machine, so the operating expenses are relevant costs.operating expenses are relevant costs.

Let’s summarize the relevant costs for the two Let’s summarize the relevant costs for the two machines.machines.


Opportunity cost 14,000$ Salvage value (2,000) Operating expenses 45,000 Total 57,000$

Cost 29,000$ Salvage value (4,000) Operating expenses 22,500 Total 47,500$

Old Machine

New Machine

Our analysis should Our analysis should that Premier should that Premier should

acquire the new acquire the new machine. Over a machine. Over a

five-year period the five-year period the company will save a company will save a

total of $9,500total of $9,500($57,000 ($57,000 – $47,500)– $47,500)

Asset Replacement Decisions

• Identify relevant costs of operating existing assets and compare with costs of operating new, replacement assets

• Company should choose the lowest cost option

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Chapter 5 Relevant Information for Special Decisions