Chapter 6
Relevant Information
and Decision Making:
Production Decisions
©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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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 available
contribution 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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Learning Objective 2
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 quality
Protect 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
$ 1
Direct labor
80,000
4
Variable overhead
40,000
2
Fixed overhead
80,000
4
Total 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.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Relevant Cost Comparison
Make
Total Per Unit
Purchase cost
Direct material
Direct labor
Variable overhead
Fixed OH avoided by
not making
Total relevant costs
Difference in favor
of making
Buy
Total
Per Unit
$200,000
$10
$ 20,000 $ 1
80,000
4
40,000
2
20,000
1
$160,000 $ 8
0
$200,000
0
$10
$ 40,000 $ 2
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Learning Objective 3
Decide whether a joint product
should be processed beyond
the split-off point.
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Joint Products
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.
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Joint Products
Separable costs are any costs beyond the
split-off point.
Joint costs are the costs of manufacturing
joint 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 a
selling price of $.09 = $90,000
Joint-processing
cost is $100,000
500,000 liters of Y at a
selling price of $.06 = $30,000
Total sales value at split-off
is $120,000
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.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Illustration of
Sell or Process Further
Sell at
Split-off
as Y
Revenue
$30,000
Separable costs
beyond split-off
@ $.08
–
Income effects
$30,000
Process
Further and
Sell as YA Difference
$80,000
$50,000
40,000
$40,000
40,000
$10,000
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Learning Objective 4
Identify irrelevant information
in disposal of obsolete inventory
and equipment replacement
decisions.
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Irrelevance of Past Costs

1
2
Two examples of past costs that we can
consider, to see why they are irrelevant to
decisions, are:
The cost of obsolete inventory
The book value of old equipment
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Example of Irrelevance of
Obsolete 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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Example of Irrelevance of
Obsolete Inventory
General Dynamics can...
1 remachine the parts for $30,000 and then
sell them for $50,000, or
2 scrap them for $5,000.
 Which should it do?

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Example of Irrelevance of
Obsolete Inventory
Remachine
Scrap
Difference
Expected future revenue $ 50,000
$ 5,000 $45,000
Expected future costs
30,000
0
30,000
Relevant excess of
revenue over costs
$ 20,000
$ 5,000 $15,000
Accumulated historical
inventory 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 Value
of Old Equipment
The book value of equipment is not a
relevant consideration in deciding
whether to replace the equipment.
Why?
Because it is a past, not a future cost.
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Irrelevance of 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.
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Example of Book Value
Computation
Suppose a $10,000 machine with a 10-year life
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
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Keep or Replace an Old Machine?
Old
Machine
Original cost
$10,000
Useful life in years
10
Current age in years
6
Useful life remaining in years
4
Accumulated depreciation
$ 6,000
Book value
$ 4,000
Disposal value (in cash) now $ 2,500
Disposal value in 4 years
0
Annual cash operating costs $ 5,000
Replacement
Machine
$8,000
4
0
4
0
N/A
N/A
0
$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

1
2
3
4
In deciding whether to replace or keep
existing equipment, we must consider the
relevance of four commonly encountered
items:
Book value of old equipment
Disposal value of old equipment
Gain or loss on disposal
Cost of new equipment
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6 - 29
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
$20,000 $12,000 $ 8,000
Cash operating costs
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
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Learning Objective 5
Explain how unit costs
can be misleading.
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Beware of Unit Costs

1
2
There are two major ways to go wrong
when using unit costs in decision making:
The inclusion of irrelevant costs
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?

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Example of
Volume Basis Decision
Units
Variable cost per unit
Variable costs
Straight-line depreciation
Total relevant costs
Unit relevant costs
Old
Machine
100,000
$1.50
$150,000
0
$150,000
$1.50
New
Machine
100,000
$1.00
$100,000
20,000
$120,000
$1.20
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Example of
Volume Basis Decision
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.

©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton
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Example of
Volume Basis Decision
Units
Variable cost per unit
Variable costs
Straight-line depreciation
Total relevant costs
Unit relevant costs
Old
Machine
30,000
$1.50
$45,000
0
$45,000
$1.50
New
Machine
30,000
$1.00
$30,000
20,000
$50,000
$1.6667
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6 - 40
Learning Objective 6
Discuss how performance
measures can affect
decision making.
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6 - 41
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 on
Decision 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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Example of Effect on
Decision Making
Year 1
Keep
Replace
Cash operating
costs
Depreciation
Loss on disposal
($4,000 – $2,500)
Total charges
against revenue
Years 2, 3, and 4
Keep
Replace
$5,000
1,000
$3,000
2,000
$5,000
1,000
$3,000
2,000
0
$1,500
0
0
$6,000
$6,500
$6,000
$5,000
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Example of Effect on
Decision Making
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.
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Learning Objective 7
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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