Instructor: Michael Booth

Cabrillo College

Week 13, Chap 12Relevant Information for Special Decisions

Overview Costs – Resources sacrificed to achieve specific objective i.e.

manufacturing a specific product or provided a specific service

Expenses – costs charged against revenue in a particular accounting period

Learning Objective

To identify the

characteristics of

relevant information

Focus on future costs and future revenues that differ among decision alternatives.

Organize them in a manner that clearly indicates how they differ under each alternative.

Identifying Relevant Costs

Davis Driveways, Inc. (DDI) pours concrete driveways for single

family homes. DDI uses a cost-plus pricing approach. The

company’s accountant prepared the following report showing how

DDI established the price per driveway at $350.

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.

In Class Demonstration Case A new builder in town, Rachel Rodgers, has acquired a

large tract of land upon which she intends to build 200 single family homes. Ms. Rodgers offers to purchase all 200 driveways from DDI. However, she is willing to pay only $250 per driveway.

Required:

Assume your group is a management team responsible for deciding whether to accept or reject Ms. Rodgers’ offer. Develop a response, support your decision with appropriate computations, and choose a spokesperson to explain your answer.

Overview of Concepts Relevant Costs

Sunk Costs

Opportunity Cost

Relevant Cost Specific to a particular decision

Relevant cost of the particular decision changes if alternative course of action is taken

Sometimes refered to as “differential costs”

Identifying Relevant CostsAn avoidable cost is a cost that can be eliminated, in

whole or in part, by choosing one alternative over

another.

• Avoidable costs are relevant costs.

• Unavoidable costs are irrelevant costs.

Relevant Cost Analysis: A Two-

Step Process

Eliminate costs and benefits that do not differ

between alternatives.

Use the remaining costs and benefits that

differ between alternatives in making the

decision. The costs that remain are the

differential, or avoidable, costs.

Step 1

Step 2

Identifying Relevant Costs

Sunk costs are never relevant.

Two broad categories of costs are never

relevant in any decision. They include:

Sunk costs.

Future costs that do not differ

between the alternatives.

A sunk cost has been incurred in a past

transaction and cannot be changed. It is

not relevant for making current decisions.

Relevance Is an Independent

Concept

Which costs are relevant?

•Costs are relevant because they differ

• Whether a cost is fixed or variable has no bearing on its relevance.

• A particular cost that is relevant in one context may be

irrelevant in another.

Sunk Costs

Sunk costs result

from past decisions

that cannot be

changed.

Aside from tax

consequences, sunk

costs are never

relevant.

What are

sunk

costs?

Note: Sunk costs are never relevant!

Sunk costs(cont.):

Disposal and salvage

values Disposal and Salvage Values

Cash inflows from the disposal of assets is a relevant cash inflow

Any salvage value at the end of the useful life of the assets will also be relevant

A loss on disposal may have a favorable tax impact if the loss can be offset against taxable gains or taxable income

Sunk Costs (continue) Cost of obsolete inventory

Book Value of old equipment

Note: The ability to recognize and ignore relevant vs. sunk costs is important to decision makers support by managerial accountants

Sunk Costs (cont) Obsolete inventory (Example)

General Dynamics has 100 obsolete aircraft parts in inventory

Original manufacturing cost of parts was $100,000

Alternatives:

Re-machine parts of $30,000 and sell for $50,000

Scrap for $5,000

Sunk Costs (obsolete Inv. Cont)Re-

Machine

Scrap Difference

Expected future

Revenue

$50,000 $ 5,000 $45,000

Expected future

costs

30,000 0 30,000

Relevant excess of

revenue vs. costs

$20,000 $ 5,000 $15,000

Accumulated

historical cost of

inventory*

$100,000 $100,000 0

Net loss on Project ($80,000) ($95,000) $15,000

Note: Inventory cost is irrelevant it is unaffected by the decision

Sunk Cost (Book Value of

Equipment) Book value of equipment is not a relevant cost

Should not be used in decision for replacement of equipment It is a past cost, not a future cost

Depreciation The periodic allocation of the cost of equipment Equipment book value ( or net book value) is the original cost (historical cost) less

accumulated depreciation It is a past cost (to include accumulated depreciation), not a future cost and is not

relevant. Note: Future Depreciation can be a relevant cost

Disposal Value Is relevant It is the future inflow of cash There is a difference between disposal value and book value Book value must be evaluated separately from the irrelevant book value

Cost of New or replacement equipment It is a relevant cost, it is a future outflow

Sunk Costs Sunk costs may cause ethical dilemmas

Although the book value of an old item has no economic significance (i.e. not relevant), the accounting treatment of past costs may make it difficult for managers to regard them as irrelevant.

The possibility of recording an accounting loss may place managers in an ethical dilemma. Fearing the loss will lead to superiors questioning his or her judgment, a manager might prefer to use the old item, as opposed to replacing it and be forced to record a loss.

Cumulative effect of many such decisions will be harmful to the long-run economic health of the organization

Sunk Cost (Book value of old

equipment) cont.

Decision to keep or replace equipment

Historical cost - $10,000

10 year useful life span

Depreciation is straight-line, $1,000 per year

Book Value at the end of 6 years

Original Cost $10,000

Accumulated depreciation (6 x $1,000) 6,000

Book Value $ 4,000

Sunk Cost (Book Value of old

equipment) cont.

Old MachineReplacement Machine

Original Cost 10,000$ 8,000$ Useful life in year 10 4Current age in year 6 0Useful life remaing in yrs 4 10Accumulated Depreciation 6,000$ -$ Book Value 4,000$ N/ADisposal value (in cash) now 2,500$ NADisposal value in 4 years -$ -$ Annual Cash operating costs 5,000$ 3,000$

Sunk cost (book value vs

replacement) cont.

Book Value is irrelevant: no difference

Revelant Costs, Cost Behavior

In-class Exercise

Cost Items

Hotel

Training

Facility

Relevant?

Cost

Behavior

Product

or GS&A

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

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.

Pass Fast, Inc (cont.)Required

a. In the column titled “Relevant?” indicate whether each cost is relevant (Yes) or not relevant (No) to deciding which facility to rent for the course.

b. In the column titled “Cost Behavior” indicate whether each cost is fixed, variable, or mixed relative to the number of students attending the course.

c. In the column titled “Product or GS&A” indicate whether each cost would be classified as a product cost or a general, selling, and administrative (GS&A) cost.

Relevance Is an Independent

Concept

Which costs are relevant?

•Costs are relevant because they differ

• Whether a cost is fixed or variable has no bearing on its relevance.

• A particular cost that is relevant in one context may be

irrelevant in another.

Differential Revenue and

Avoidable Cost

Relevant revenues:

1. Must be future oriented

2. Differ for the alternatives under consideration

3. Relevant revenues differ between the alternatives, they are sometimes called differential revenues.

Avoidable Cost

1. costs managers can eliminate by making specific

choices

Opportunity Costs•An opportunity cost is the profit foregone

by selecting one alternative over another

•It is the net return that could be

realized if a resource is put to the next

best use

•It is “what we give up” from “the road

not taken”

Opportunity Costs•An opportunity cost is the profit foregone

by selecting one alternative over another

•It is the net return that could be

realized if a resource is put to the next

best use

•It is “what we give up” from “the road

not taken”

Learning Objective

Difference between:

• unit-level

• batch-level

• product level

• facility-level costs

How these costs affect decision

making.

Relevant (Avoidable) Costs

Unit-level

Costs

Batch-level

Costs

Product-level

Costs

Facility-level

Costs

Avoided by eliminating one

unit of product.

Avoided when a batch of

work is eliminated.

Avoided if a product line

is eliminated.

Some costs may be avoided

if a business segment is

eliminated.

Learning Objective

To make appropriate

special order

decisions.

Relevant Information and

Special Decisions

Occasionally, a company receives an offer to sell its

product at a price significantly below its normal selling

price. The company must make a special order decision 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 (200 units per batch)

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

Here is budgeted

cost information

for Premier, a

company that

produces printers.

The company has

enough capacity

to produce

additional

printers, but is

planning to

produce to meet

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, profitability will increase by

$11,800.

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 (200 units per batch)

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

Here is budgeted

cost information

for Premier, a

company that

produces printers.

The company has

enough capacity

to produce

additional

printers, but is

planning to

produce to meet

current demand.

Special Order DecisionOpportunity Costs

Premier has excess productive capacity. Suppose Premier

has the opportunity to lease its excess capacity (unused

building and equipment used for the additional printers) for

$15,000 vs the sale of the incremental 200 printers at $250.

Should Premier accept the special offer given this new

information?

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)

Opportunity cost (15,000)

Contribution to income (3,200)$

Relevant Information for Special Order

If the order is rejected, profitability will

decrease by $3,200.

Special Order Decision

If Premier can increase income by selling its printers

for $250, can the company reduce its normal selling

price to $250?

Relevance and the Decision Context

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 (200 units per batch)

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

Here is budgeted

cost information

for Premier, a

company that

produces printers.

The company has

enough capacity

to produce

additional

printers, but is

planning to

produce to meet

current demand.

Special Order Decision

If Premier can increase volume from 2,000 units to

2,200 unit by selling its printers for $250. Can the

company reduce its normal selling price to $250?

Relevance and the Decision Context

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

Note: Revenue, unit and batch costs increase with number of units

Special Order Decision

Should a company ever reject a special order if

the relevant revenues exceed the relevant

costs?

Qualitative Characteristics

What will happen if Premier’s regular

customers learn that the company sold

printers to another buyer for $250 per unit?

Qualitative Features

A company that uses vertical integration controls the full

range of activities from acquiring raw materials to

distributing goods and services. An oil company, like

ExxonMobil, is a good example of vertical integration.

Outsourcing reduces the level of vertical integration,

passing some of a company’s control over its

production to outside suppliers.

The Make or Buy DecisionWhen a company is involved in more than one activity in the entire value chain, it is vertically integrated. A decision to carry out one of the activities in the value chain internally, rather

than to buy externally from a supplier is called a “make or buy” decision.

Vertical Integration- Advantages

Smoother flow of

parts and materials

Better quality

control

Realize profits

Vertical Integration-Disadvantage

Companies may fail to

take advantage of

suppliers who can

create economies of

scale advantage by

pooling demand from

numerous companies.

While the economics of scale factor can be

appealing, a company must be careful to retain

control over activities that are essential to

maintaining its competitive position.

In-class exercise Carroll Company

Instructor: Michael Booth

Cabrillo College

Carroll Company Complete a, b, & c

Does the volume make a difference? Why?

What should be the controls for the qualitative factors?

Carroll Company (cont.)Quantity 100,000

Batch size 1000

# batches 100

Materials cost 5.00$ 500,000.00$

Labor cost 4.00$ 400,000.00$

Manufacturing supplies 0.50$ 50,000.00$

Batch-Level Costs 2,000.00$ 200,000.00$

Product level Costs 150,000.00$ 150,000.00$

Facility-Level Costs 180,000.00$ 180,000.00$

Total Costs 1,480,000.00$

Cost Per unit 14.80$

Carroll CompanyA. Bypassing Carroll’s regular distribution channel, Granado’s Home

Maintenance Company, has offered to buy a batch of 500 electric drills for $12.50 each directly from Carroll. Carroll’s normal selling price is $20 per unit. Based on the preceding quantitative data, should Carroll accept the special order? Support your answer with appropriate computations.

B. Would your answer to requirement “A” change if Granado’s offered to buy a batch of 1,000 electric drills for $11.60 each. Support your answer with appropriate computations

C. Describe the Qualitative Factors that Carroll should consider before accepting a special order to sell electric drills.

Carroll Company

Alternative (a) 500 drills

Quantity 500

Batch size 1000

# batches 1

Materials cost 5.00$ 2,500.00$

Labor cost 4.00$ 2,000.00$

Manufacturing supplies 0.50$ 250.00$

Batch-Level Costs 2,000.00$ 2,000.00$

Product level Costs 150,000.00$ -$

Facility-Level Costs 180,000.00$ -$

Total Costs 6,750.00$

Cost Per unit 13.50$

Price offered $12.50 Cost =$13.50

Carroll Company

Alternative (b) 1000 drills

Quantity 1,000

Batch size 1000

# batches 1

Materials cost 5.00$ 5,000.00$

Labor cost 4.00$ 4,000.00$

Manufacturing supplies 0.50$ 500.00$

Batch-Level Costs 2,000.00$ 2,000.00$

Product level Costs 150,000.00$ -$

Facility-Level Costs 180,000.00$ -$

Total Costs 11,500.00$

Cost Per unit 11.50$

Price offered $11.60 Cost =$11.50

Outsourcing decisionPleasant Toy Company

Pleasant Toy CompanyModel K Model K

Quantity 15,000

Unit-level material costs 6$ 90,000$

Unit-level labor costs 20$ 300,000$

Unit-level overhead costs 8$ 120,000$

Depreciation 48,000$ 48,000$

Model K production

Supervisor Salary 42,000$ 42,000$

Inventory Holding Cost 108,000$ 108,000$

Allocated portion of

Facitly cost 72,000$ 72,000$

Total Costs 780,000$

Cost per Unit 52.00$

OutSourcing Decision

Pleasant Toy CompanyAdditional Information:

1. The manufacturing equipment originally cost $420,000 and has a book value of $240,000, a remaining useful life of four years, and zero salvage value. If the equipment is not used to produced Model K in the production process, it can be leased for $36,000

2. Pleasant has the opportunity to purchase for $200,000 new manufacturing equipment that will have an expected useful life of four years and salvage value of $80,000. This equipment will increase productivity substantially, thereby reducing unit-level LABOR costs by 20%

3. If Pleasant discontinues the production of Model K, the company can eliminate 50 % of its inventory holding cost

4. An Independent contractor has offered to make the same product for Pleasant for $42 each

Pleasant Toy CompanyA. Determine the avoidable cost per unit to produce Model K assuming that

Pleasant is considering the alternatives between making the product using the existing equipment and outsourcing the product to the independent contractor. Based on the quantitative data, should Pleasant outsource Model K?

B. Assuming the Pleasant is considering whether to replace the old equipment with the new equipment, determine the avoidable costs (relevant) per unit to produce Model K using the new equipment and the avoidable cost (relevant) per unit to produce Model K using the old equipment. Calculate the impact of profitability of Model K were made using the old equipment vs the new equipment.

C. Assuming that Pleasant is considering either to purchase the new equipment or to outsource Model K, calculate the impact on profitability between the two alternatives.

Pleasant Toy Company

(a) outsource $42 comparison

Quantity 15,000 Make . BUY

Unit-level material costs 6$ 90,000$ 90,000$ Unit-level labor costs 20$ 300,000$ 300,000$ Unit-level overhead costs 8$ 120,000$ 120,000$ Depreciation 48,000$ 48,000$ -$

Model K production Supervisor Salary 42,000$ 42,000$ 42,000$ Inventory Holding Cost 108,000$ 108,000$ 54,000$

Allocated portion of Facitly cost 72,000$ 72,000$ -$

Lease 36,000$

Total Costs 780,000$ 642,000$ 630,000$

Cost per Unit 52.00$ 42.80$ 42.00$

Pleasant Toy Company

(b) Existing vs New

Model K Model K

Avoidable Model K

Relevant

Avoidable

Replacement Avoidable Costs

Quantity 15,000

Unit-level material costs 6$ 90,000$ -$

Unit-level labor costs 20$ 300,000$ 300,000$ 240,000$ 60,000$

Unit-level overhead costs 8$ 120,000$ -$

Depreciation 48,000$ 48,000$ -$ 30,000$ (30,000)$

Model K production

Supervisor Salary 42,000$ 42,000$ -$

Inventory Holding

Cost 108,000$ 108,000$ -$

Allocated portion of

Facitly cost 72,000$ 72,000$ -$

Lease 36,000$ 36,000$

Total Costs 780,000$ 336,000$ 270,000$ 66,000$

Cost per Unit 52.00$ 22.40$ 18.00$ 4.40$

Pleasant Toy Company(c) outsource $42 comparison vs new

Model K Model K Model K Relevant Replacement

Quantity 15,000 BUY New Machine

Unit-level material costs 6$ 90,000$ 90,000$

Unit-level labor costs 20$ 300,000$ 240,000$

Unit-level overhead costs 8$ 120,000$ 120,000$

Depreciation 48,000$ -$ 30,000$

Model K production

Supervisor Salary 42,000$ 42,000$ 42,000$

Inventory Holding

Cost 108,000$ 108,000$ 54,000$

Allocated portion of

Facitly cost 72,000$ 72,000$ -$

Lease

Total Costs 732,000$ 630,000$ 576,000$

Cost per Unit 48.80$ 42.00$ 38.4

Outsourcing vs Replacement = $42 – 38.40 = $3.60 x 15,000

$54,000 net increase to income

Joint Costs/ Split off

Costs

Joint Costs/Split-off Point Cost allocation problems arise if two or more products (frequently

intermediate products) emerge from a SINGLE production process. This situation is rather common in the manufacture of chemicals and semiconductors. Joint costs: all manufacturing costs incurred prior to the split off point.

Joint Costs are never relevant

Split off point : the stage of production at which the different individual products can be separately identified.

Joint Costs/Split-off point Separable Costs: costs incurred beyond the split-off

point that are assignable to the individual products

yielded by an initially identical process.

Separable Costs are relevant (differential)