Chapter 6

6 - 1©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

Chapter 6

Relevant Information

and Decision Making:

Production Decisions

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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

Learning Objective 1

Use opportunity cost to

analyze the income

effects of a given

alternative.

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Costs

An opportunity cost is the maximum availablecontribution to profit forgone (or passed up)by using limited resources for a particular purpose.

An outlay cost requires a cash disbursement.

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Costs

Differential cost and incremental cost are defined as the difference in total cost between two alternatives.

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Decide whether to make or buy

certain parts or products.

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Make-or-Buy Decisions

The basic make-or-buy question is whether a company should make its own parts to be used in its products or buy them from vendors.

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Make-or-Buy Decisions

Qualitative Factors:Control qualityProtect long-term relationships with suppliers

Quantitative Factors: Idle facilities or capacity

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Make-or-Buy Example

GE Company Cost of Making Part N900: Total Cost for Cost 20,000 Units per Unit

Direct material $ 20,000 $ 1Direct labor 80,000 4Variable overhead 40,000 2Fixed overhead 80,000 4Total costs $220,000 $11

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Make-or-Buy Example

Another manufacturer offers to sell GE the same part for $10.

The essential question is the difference in expected future costs between the alternatives.

Should GE make or buy the part?

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Make-or-Buy Example

If the $4 fixed overhead per unit consists of costs that will continue regardless of the decision, the entire $4 becomes irrelevant.

If $20,000 of the fixed costs will be eliminated if the parts are bought instead of made, the fixed costs that may be avoided in the future are relevant.

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Relevant Cost Comparison

Make Buy Total Per Unit Total Per Unit

Purchase cost $200,000 $10Direct material $ 20,000 $ 1Direct labor 80,000 4Variable overhead 40,000 2Fixed OH avoided by not making 20,000 1 0 0 Total relevant costs $160,000 $ 8 $200,000 $10Difference in favor of making $ 40,000 $ 2

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Decide whether a joint product

should be processed beyond

the split-off point.

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Joint Products

Joint products have relatively significantsales values.

They are not separately identifiable asindividual products until their split-off point.

The split-off point is that juncture ofmanufacturing where the joint productsbecome individually identifiable.

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Joint Products

Separable costs are any costs beyond thesplit-off point.

Joint costs are the costs of manufacturingjoint products before the split-off point.

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Illustration of Joint 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.

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Illustration of Joint Costs

1 million liters of X at aselling price of $.09 = $90,000

500,000 liters of Y at aselling price of $.06 = $30,000

Total sales value at split-offis $120,000

Joint-processingcost is $100,000

Split-off point

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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.

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Illustration of Sell or Process Further

Revenue $30,000 $80,000 $50,000Separable costs beyond split-off @ $.08 – 40,000 40,000Income effects $30,000 $40,000 $10,000

Sell atSplit-off

as Y

ProcessFurther andSell as YA Difference

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Identify irrelevant information

in disposal of obsolete inventory

and equipment replacement

decisions.

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Irrelevance of Past Costs

Two examples of past costs that we can consider, to see why they are irrelevant to decisions, are:

1 The cost of obsolete inventory2 The book value of old equipment

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Example of Irrelevance ofObsolete Inventory

Suppose General Dynamics has 100 obsolete aircraft parts in its inventory.

The original manufacturing cost of these parts was $100,000.

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General Dynamics can...1 remachine the parts for $30,000 and then

sell them for $50,000, or2 scrap them for $5,000. Which should it do?

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Remachine Scrap Difference

Expected future revenue $ 50,000 $ 5,000 $45,000Expected future costs 30,000 0 30,000Relevant excess ofrevenue over costs $ 20,000 $ 5,000

$15,000Accumulated historicalinventory cost* 100,000 100,000

0 Net loss on project $(80,000) $ (95,000)

$15,000*Irrelevant because it is unaffected by the decision.

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Irrelevance of Book Valueof Old Equipment

The book value of equipment is not arelevant consideration in decidingwhether to replace the equipment.

Why?

Because it is a past, not a future cost.

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Irrelevance of Book Valueof Old Equipment

Depreciation is the periodic allocation of the costof equipment.

The equipment’s book value (or net book value)is the original cost less accumulated depreciation.

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Example of Book Value Computation

Suppose a $10,000 machine with a 10-year lifehas depreciation of $1,000 per year.

What is the book value at the end of 6 years?

Original cost $10,000Accumulated depreciation (6 × $1,000) 6,000Book value $ 4,000

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Keep or Replace an Old Machine?

Old ReplacementMachine Machine

Original cost $10,000 $8,000Useful life in years 10 4Current age in years 6 0Useful life remaining in years 4 4Accumulated depreciation $ 6,000 0Book value $ 4,000 N/ADisposal value (in cash) now $ 2,500 N/ADisposal value in 4 years 0 0Annual cash operating costs $ 5,000 $3,000

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Keep or Replace an Old Machine?

What is a sunk cost? A sunk cost is a cost that has already been

incurred and, therefore, is irrelevant to the decision-making process.

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Relevance of Equipment Data

In deciding whether to replace or keep existing equipment, we must consider the relevance of four commonly encountered items:

1 Book value of old equipment2 Disposal value of old equipment3 Gain or loss on disposal4 Cost of new equipment

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Book Value of Old Equipment

The book value of old equipment is irrelevant because it is a past (historical) cost.

Therefore, depreciation on old equipment is irrelevant.

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Disposal Value of Old Equipment

The disposal value of old equipment is relevant (ordinarily) because it is an expected future inflow that usually differs among alternatives.

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Gain or Loss on Disposal

This is the difference between book value and disposal value.

It is therefore a meaningless combination of irrelevant (book value) and relevant items (disposal value).

It is best to think of each separately.

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Cost of New Equipment

The cost of the new equipment is relevant because it is an expected future outflow that will differ among alternatives.

Therefore depreciation on new equipment is relevant.

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Comparative Analysis of the Two Alternatives

Four Years Together Keep Replace Difference

Cash operating costs $20,000 $12,000 $ 8,000Old equipment (book value)depreciation, or 4,000 – –lump-sum write-off 4,000 –Disposal value – (2,500) 2,500New machineacquisition cost – 8,000 (8,000)Total costs $24,000 $21,500 $ 2,500

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Explain how unit costs

can be misleading.

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Beware of Unit Costs

There are two major ways to go wrong when using unit costs in decision making:

1 The inclusion of irrelevant costs2 Comparisons of unit costs not computed on

the same volume basis

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Example of Volume Basis Decision

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?

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Old New Machine Machine

Units 100,000 100,000Variable cost per unit $1.50 $1.00Variable costs $150,000 $100,000Straight-line depreciation 0 20,000Total relevant costs $150,000 $120,000Unit relevant costs $1.50 $1.20

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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.

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Old NewMachine Machine

Units 30,000 30,000Variable cost per unit $1.50 $1.00Variable costs $45,000 $30,000Straight-line depreciation 0 20,000Total relevant costs $45,000 $50,000Unit relevant costs $1.50 $1.6667

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Discuss how performance

measures can affect

decision making.

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Performance Measures Can Affect Decision Making

To motivate managers to make the right choices, the method used to evaluate performance should be consistent with the decision model.

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Example of Effect onDecision Making

Consider the replacement decision, discussed earlier, where replacing the machine had a $2,500 advantage over keeping it.

Because 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.

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Year 1 Years 2, 3, and 4 Keep Replace Keep Replace

Cash operatingcosts $5,000 $3,000 $5,000 $3,000Depreciation 1,000 2,000 1,000 2,000Loss on disposal($4,000 – $2,500) 0 $1,500 0 0Total chargesagainst revenue $6,000 $6,500 $6,000 $5,000

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If the machine is kept rather than replaced,first-year costs will be $500 lower($6,500 – $6,000), and first-yearincome will be $500 higher.

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Construct absorption and

contribution format income

statements and identify which

is better for decision making.

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Absorption Approach

The absorption approach is a costing approach that considers all factory overhead (both variable and fixed) to be product (inventoriable) costs.

Factory overhead becomes an expense in the form of manufacturing cost of goods sold only as sales occur.

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Contribution Approach

In contrast, the contribution approach is used by many companies for internal (management accounting) reporting.

It emphasizes the distinction between variable and fixed costs.

The contribution approach is not allowed for external financial reporting.

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Chapter 6