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?
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“Make or Buy” Decision
• Essex manufactures part 4A that is
currently used in one of its products.
• The unit cost to make this part is:
Dire
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Totall cost
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$$
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11
33
22
10
10
$$ 30
30
“Make or Buy” Decision
• The special equipment used to manufacture
part 4A has no resale value
• General factory overhead is allocated on the
basis of direct labor hours
• The $30 total unit cost is based on 20,000
parts produced each year
• An outside supplier has offered to provide
the 20,000 parts at a cost of $25 per part
• Should we accept the supplier’s offer?
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
Special Orders
 Jet, Inc. makes a single product whose normal selling
price is $20 per unit.
 A foreign distributor offers to purchase 3,000 units for
$10 per unit.
 This is a one-time order that would not affect the
company’s regular business.
 Annual capacity is 10,000 units, but Jet, Inc. is currently
producing and selling only 5,000 units.
Should Jet accept the offer?
Special Orders
Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20)
$ 100,000
Variable costs:
Direct materials
$ 20,000
Direct labor
5,000
Manufacturing overhead
10,000 $8 variable cost
Marketing costs
5,000
Total variable costs
40,000
Contribution margin
60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs
20,000
Total fixed costs
48,000
Net operating income
$ 12,000
Accept or Reject a Special Order
Jamestown Candleworks has just received a request from the Williamsburg
Foundation for 800 candles to be used in a special event for major donors. The
candles will be used as the only illumination in the reception room and will be
given out as gifts to the donors as they leave. The candles will be imprinted
with the Williamsburg Foundation logo. This sale will have no effect on the
company’s normal sales to retail outlets. The normal selling price of a candle
of about the size and weight of the special candles is $3.95 and its unit product
cost is $2.30, as shown below:
Direct materials
Direct labor
Manufacturing overhead
Unit product cost
$1.35
0.15
0.80
$2.30
The variable portion of the manufacturing overhead is $0.05 per candle; the
other $0.75 represents fixed manufacturing costs that would not be affected by
this special order.
Accept or Reject a Special Order (continued)
Jamestown Candleworks would have to order a special
candle mold in which the Williamsburg Foundation logo is
inscribed. Such a mold would cost $800. In addition, the
Williamsburg Foundation wants a special wick containing goldlike thread that would add $0.20 to the cost of each candle.
Because of the large size of the order and the charitable
nature of the work, the Williamsburg Foundation has asked to
pay only $2.95 each for this candle.
If accepted, what effect would this order have on the
company’s net operating income?
Accept or Reject a Special Order
Your firm has the capacity to produce 10,000 pencils monthly.
It’s December 15th. To date your firm has orders for 8,000
pencils. You don’t anticipate getting any more orders until
next January.
Your cost and revenue information is as follows:
Sales price per pencil
$
10
Variable cost per pencil
3
Total fixed costs
$28,000
Accept or Reject a Special Order
Jack Frost,Mayor of Burnville, comes to you and says he
would like to give all his staff pencils as Christmas presents,
but doesn’t want to pay a lot for them. He offers you $4 per
pencil for 2,000 pencils.
Should you take this deal?
Accept or Reject a Special Order
What if, instead, Jack Frost says he will give you $4 per
pencil for 4,000 pencils.
Should you take this deal?
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?
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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?