Chapter 11
Decision making:
Relevant Costs and Benefits
DIFFERENTIAL COSTS AND REVENUES
Bill is currently employed as a lifeguard, but he has been offered a
job in an auto service center in the same town. The differential
revenues and costs between the two jobs are listed below:
Lifeguard
Monthly salary
Auto
Service
Center
Differential
costs and
revenues
$1,200
$1,500
$300
30
90
60
Meals
150
150
0
Apartment rent
450
450
0
0
50
50
10
0
640
740
100
$ 560
$ 760
$200
Monthly expenses:
Commuting
Uniform rental
Union dues
Total monthly expenses
Net monthly income
(10)
Identifying Relevant Costs
Automobile Costs (based on 10,000 miles driven per year)
1
2
3
4
5
6
Annual straight-line depreciation on car
Cost of gasoline
Annual cost of auto insurance and license
Maintenance and repairs
Parking fees at school
Total average cost
7
8
9
10
11
12
13
Annual Cost
of Fixed Items
$
2,800
1,380
360
Cost per
Mile
$
0.280
0.050
0.138
0.065
0.036
$
0.569
Some Additional Information
Reduction in resale value of car per mile of wear
Round-trip train fare
Cost of hotel in New York
Cost of putting dog in kennel while gone
Benefit of having car in New York
Hassle of parking car in New York
Per day cost of parking car in New York
$ 0.026
$
104
$
200
$
40
????
????
$
25
Total and Differential Cost Approaches
The management of a company is considering a new laborsaving
machine that rents for $3,000 per year. Data about the company’s
annual sales and costs with and without the new machine are:
Sales (5,000 units @ $40 per unit)
Less variable expenses:
Direct materials (5,000 units @ $14 per unit)
Direct labor (5,000 units @ $8 and $5 per unit)
Variable overhead (5,000 units @ $2 per unit)
Total variable expenses
Contribution margin
Less fixed expense:
Other
Rent on new machine
Total fixed expenses
Net operating income
Current
Situation
$
200,000
Situation
With New
Machine
$
200,000
Differential
Costs and
Benefits
-
70,000
40,000
10,000
120,000
80,000
70,000
25,000
10,000
105,000
95,000
15,000
15,000
62,000
62,000
18,000
62,000
3,000
65,000
30,000
(3,000)
(3,000)
12,000
$
$
Analysis of Special Decisions
Let’s take a look at another decision faced by many businesses.
We need a particular component for our
manufacturing process. Do you think we should
make or buy this particular item?
W
Make or Buy
Han Products manufactures 30,000 units of part S-6 each year
for use on its production line. At this level of activity, the cost
per unit for part S-6 is as follows:
Direct materials
Direct labor
Variable manufacturing overhead
Fixed manufacturing overhead
Total cost per part
$3.60
10.00
2.40
9.00
$25.00
Make or Buy (continued)
An outside supplier has offered to sell 30,000 units of part S-6
each year to Han Products for $21 per part. If Han Products
accepts this offer, the facilities now being used to manufacture
part S-6 could be rented to another company at an annual
rental of $80,000. However, Han Products has determined that
two-thirds of the fixed manufacturing overhead being applied to
part S-6 would continue even if part S-6 were purchased from
the outside supplier.
Prepare computations showing how much profits will increase
or decrease if the outside supplier’s offer is accepted.
Analysis of Special Pricing Decisions
Let’s take a look at another decision faced by many businesses:
Another firm has offered to pay us $10 for a product
that normally sells for $25. Do you think we should
accept this special order?
W
Accept/Reject Special Orders
Polaski Company manufactures and sells a single product called a Ret.
Operating at capacity, the company can produce and sell 30,000 Rets
per year. Costs associated with this level of production and sales are
given below:
Unit
Total
Direct materials
$15 $450,000
Direct labor
8
240,000
Variable manufacturing overhead
3
90,000
Fixed manufacturing overhead
9
270,000
Variable selling expense
4
120,000
Fixed selling expense
6
180,000
Total cost
$45 $1,350,000
The Rets normally sell for $50 each. Fixed manufacturing overhead is
constant at $270,000 per year within the range of 25,000 through
30,000 Rets per year.
Accept/Reject Special Orders (continued)
Assume that due to a recession, Polaski Company expects to sell
only 25,000 Rets through regular channels next year. A large
retail chain has offered to purchase 5,000 Rets if Polaski is
willing to accept a 16% discount off the regular price. There
would be no sales commissions on this order; thus, variable
selling expenses would be slashed by 75%.
However, Polaski Company would have to purchase a special
machine to engrave the retail chain’s name on the 5,000 units.
This machine would cost $10,000. Polaski Company has no
assurance that the retail chain will purchase additional units in
the future. Determine the impact on profits next year if this
special order is accepted.
Accept/Reject Special Orders (continued)
Refer to the original data. Assume again that Polaski Company
expects to sell only 25,000 Rets through regular channels next
year. The U.S. Army would like to make a one-time-only
purchase of 5,000 Rets. The Army would pay a fixed fee of
$1.80 per Ret, and it would reimburse Polaski Company for all
costs of production (variable and fixed) associated with the
units. Because the army would pick up the Rets with its own
trucks, there would be no variable selling expenses associated
with this order.
If Polaski Company accepts the order, by how much will profits
increase or decrease for the year?
Accept/Reject Special Orders (continued)
Assume the same situation as that described in the previous
slide, except that the company expects to sell 30,000 Rets
through the regular channels next year. Thus, accepting the
U.S. Army’s order would require giving up regular sales of
5,000 Rets.
If the Army’s order is accepted, by how much will profits
increase or decrease from what they would be if the 5,000 Rets
were sold through regular channels?
Carrying Costs of Inventory
Annual estimated stereo CD player requirements for next year
1,000,000 units
Cost per unit when each purchase is equal to 10,000 units
$16.00
Cost per unit when each purchase is equal to or greater than 500,000 units;
$16 minus 1% discount
$15.84
Cost of a purchase order
$500
Alternatives under consideration:
A. Make 100 purchases of 10,000 units each during next year
B. Make 2 purchases of 500,000 units during the year
Average investment in inventory:
A. (10,000 units x $16.00 per unit) / 2 a
B. (500,000 units x $15.84 per unit / 2 a
Annual rate of return if cash is invested elsewhere (for example, bonds or stocks
at the same level of risk as investment in inventory)
$80,000
$3,960,000
9%
a
The example assumes that stereo-CD-player purchases will be used uniformly throughout the year. The average investment in inventory
during the year is the cost of the inventory when a purchase is received plus the cost of inventory just before the next purchase is delivered (in
our example, zero) divided by 2.
Soho will pay cash for the stereo CD players it buys. Which
purchasing alternative is more economical for Soho?
Scarce Resource Constraint
A company has two products: a plain cellular
phone and a fancier cellular phone with many
special features:
Selling price
Variable costs
Contribution margin
Contribution-margin ratio
Plain
Phone
$ 80
64
$ 16
20%
Fancy
Phone
$ 120
84
$ 36
30%
Scarce Resource Constraint
Which product is more profitable?
On which should the firm spend its resources?
It depends.
If sales are restricted by demand for only a limited number
of phones, fancy phones are more profitable.
Scarce Resource Constraint
Suppose annual demand for phones of both types is more than
the company can produce in the next year.
Only 10,000 hours of capacity are available
If in one hour plant workers can make either three plain
phones or one fancy phone, which phone is more profitable?
Scarce Resource Constraint
1. Units per hour
2. Contribution margin per unit
Contribution margin per hour
Total contribution for
10,000 hours
Plain
Phone
3
$ 16
Fancy
Phone
1
$ 36
Another Scarce Resource Decision
Power Recreation assembles two engines - a snowmobile engine and
a boat engine - at its Lexington, Kentucky, plant.
Selling Price
Variable cost per unit
Contribution margin per unit
Contribution margin
percentage
($240/$800; $375/$1,000)
Snowmobile
Boat
Engine
Engine
$800 $1,000
560
625
$240
$375
30%
37.5%
Scarce Resource Decision (cont.)
Assume that only 600 machine-hours are available daily
for assembling engines. Additional capacity cannot be
obtained in the short run. Power Recreation can sell as
many engines as it produces. The constraining resource,
then, is machine-hours. It takes two machine-hours to
produce one snowmobile engine and five machine-hours
to produce one boat engine.
What product mix should Power Recreation choose to
maximize its operating income?
Analysis of Equipment Replacement Decisions
Let’s take a look at another decision faced by many businesses:
Should we replace a machine with a newer and more
efficient one?
W
Equipment Replacement Decision
A manager at White Co. wants to replace an old machine with a new, more
efficient machine:
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Equipment Replacement Decision
White’s sales are $200,000 per year
Fixed expenses, other than depreciation, are $70,000 per year
Should the manager purchase the new machine?
Another Equipment Replacement Decision
Toledo Company is considering replacing a
metal-cutting machine with a newer model. The
new machine is more efficient than the old
machine, but it has a shorter life. Revenues
from aircraft parts ($1.1 million per year) will
be unaffected by the replacement decision.
Here’s the data on the existing (old) machine
and the replacement (new) machine:
Equipment Replacement Decision (cont.)
Old Machine
Original Cost
New Machine
$1,000,000
$600,000
Useful Life
5 years
2 years
Current age
3 years
0 years
Remaining useful life
2 years
2 years
Accumulated Depreciation
$600,000 Not acquired yet
Book Value
$400,000 Not acquired yet
Current disposal value (in cash)
Terminal disposal value (in cash 2 years
from now)
Annual operating costs (maintenance,
energy, repairs, coolants, and so on)
$40,000 Not acquired yet
$0
$0
$800,000
$460,000
Equipment Replacement Decision (cont.)
Toledo Corporation uses straight-line
depreciation. To focus on relevance, we
ignore time value of money and income
taxes.
Should Toledo replace its old machine?