Relevant costs and revenues
How to identify relevant information
in an “sea” of information.
What product costs are relevant?
Kinds of decisions
•
•
•
•
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Purchase of new equipment
Special orders
Dropping/adding a product line
Dropping/adding a segment
Make or buy
Important information
characteristics
• Accurate
• Timely
• Relevant
What is relevant information?
Relevant information differs across decision
alternatives.
Relevant costs are avoidable (escapable ) costs.
All costs are considered avoidable except:
Sunk costs
Costs that don’t differ
across decision alternatives
Sunk costs
• Basketball tickets
• Tickets to the theater
• Investments in business projects
Other cost concepts
• Outlay costs
• Opportunity costs
Steps in the decision process
• Define the objective and determine the decision
criterion
• Identify the potential courses of action
• Assemble all of the costs associated with each
alternative under consideration
• Eliminate the costs that are sunk
• Eliminate the costs that do not differ across
alternatives
• Make a decision based on the remaining costs
Village Pizza
Village Pizza’s owner bought his current pizza oven two
years ago for $9000, and it has one more year of life
remaining. He is using straight-line depreciation for the
oven. He could purchase a new oven for $1900, but it
would last only one year.
The owner figures the new oven would save him $2600 in
annual operating costs. Consequently he has decided
against buying the new oven, since doing so would result
in a loss of $400 over the next year.
Village Pizza
How do you suppose the owner came up with
$400 as the loss for the next year if the new
pizza oven were purchased? Explain.
Village Pizza
What is wrong with the owner’s analysis?
Provide a correct analysis.
Special orders
• Should production be increased to produce the special
order?
• Yes, if the change in revenues exceeds the change in
costs.
• Does the company have excess capacity?
• Will the increase in revenues exceed out-of-pocket
costs?
• Are there strategic issues not captured by the financial
analysis?
Interlaken Chemical Company
Interlaken Chemical company recently received an order for a
product it does not normally produce. Since the company has
excess production capacity, management is considering
accepting the order.
Production of the special order would require 8000 kilograms
of theolite. Interlaken does not use theolite for its regular
product, but the firm has 8000 kilograms of the chemical on
hand from the days when it used theolite regularly. The book
value of the theolite is $2 per kilogram. The theolite could be
sold to a chemical wholesaler for $14,500. Interlaken could
buy theolite for $2.40 per kilogram.
Interlaken Chemical Company
• How would we normally solve this
problem?
–
–
–
–
Define the decision criterion
Define the alternatives
Assemble the costs: Product costs
Eliminate those that are sunk or that do not
differ across alternatives
– Choose based on the remaining costs
Interlaken Chemical Company
• For this problem, we’re working to
assemble the costs. What is the relevant
cost of the DM theolite?
Interlaken Chemical Company
• Interlaken’s special order also requires 1,000 kilograms of
genatope, a solid chemical regularly used in the company’s
products. The current stock of genatope is 8,000 kilograms with
a book value of $8.10 per kilogram.
• If the special order is accepted, the firm will be forced to restock
genatope earlier than expected, at a predicted cost of $8.70 per
kilogram. Without the special order, the purchasing manager
predicts that the price will be $8.30, when normal restocking
takes place. Any order of genatope must be in the amount of
5,000 kilograms.
Interlaken Chemical Company
• What is the relevant cost of genatope?
Mr. Smith’s trip home
• Mr. Smith purchased a round trip airline ticket from Durham,
NC, to St. Louis, MO. He flew to St. Louis on Monday and
planned to return on Friday. Unknown to him, the corporate jet
also made the trip to St. Louis this week and was scheduled to
return on Friday. Mr. Smith thought he might as well save the
company some money, so he cashed in his return ticket and flew
home on the corporate jet. Did he make the correct decision?
– Was the cost of flying the corporate jet from St. Louis to
Durham relevant?
– Was the cost of the one-way commercial flight relevant?
– What would shareholders want Mr. Smith to do?
Mr. Smith’s trip home
Mr. Smith is a manager in his company and he is
evaluated based on his division’s profit. When Mr.
Smith received his divisional income statement for
the month, he discovered he had been charged more
than twice the cost of the commercial airline ticket
for his trip on the corporate jet. Mr. Smith called
Accounting to question the charge and was told that
passengers were always allocated a share of the cost
of the trip. Mr. Smith was charged the same amount
as the Vice President who ordered the trip. Did he
make the correct decision?
Bonner Company: make or buy
A vendor has offered to supply a component for $19 (FOB
destination) that has previously been manufactured internally.
Should Bonner make or buy?
Per unit
8000 units
DM
$6
$48,000
DL
4
32,000
Variable overhead
1
8,000
Supervisor’s salary
3
24,000
Depreciation of spec. equip.
2
16,000
Allocated general overhead
5
40,000
Total cost
$21
$168,000
Bonner Company: make or buy
• Suppose the firm can use the space freed up
if they do not manufacture to produce
another product that will contribute
$60,000. Should they make or buy?
Xyon Company: make or buy
Xyon Co. has purchased 10,000 pumps annually from Kobec, Inc.
Because the price keeps increasing and reached $68 per unit last
year, Xyon’s management has asked for an estimate of the cost of
manufacturing the pump in Xyon’s own facilities. Xyon makes
stampings and castings and has little experience with products
requiring assembly.
The engineering, manufacturing, and accounting departments have
prepared a report for management which includes the estimate
shown (next slide) for an assembly run of 10,000 pumps. Additional
production employees would be hired to manufacture the pumps, but
no additional equipment, space or supervision would be needed.
Xyon Company: make or buy
• The report states that total costs for 10,000 units are
estimated at $957,000 or $95.70 per unit. The current
purchase price is $68 a unit, so the report recommends
continued purchase of the product.
Components
$120,000
Assembly labor*
300,000
Manufacturing overhead**
450,000
General and admin. Overhead***
87,000
Total costs
$957,000
*Assembly labor consists of hourly production workers
**Mfg O/H is applied to products on a DL$ basis. VOH is
50%. FOH is 100%
***General and admin. is 10% of other costs.
Xyon Company: make or buy
• Should Xyon make or buy? What is the cost to
make? To buy?
Leland Mfg: make or buy
Leland Mfg. Company uses 10 units of part KJ37 each month in
the production of radar equipment. The cost of manufacturing one
unit of KJ37 is the following:
Direct material
$1,000
Material handling (20% of DM$)
200
Direct labor
8,000
Manufacturing overhead (150% of DL$) 12,000
Total cost
$21,200
Material handling represents the direct variable costs of the
Receiving Dept. that are applied to direct materials and purchased
components on the basis of their cost.
Leland Mfg.: make or buy
Leland’s annual manufacturing overhead budget is one-third
variable and two-thirds fixed. Scott Supply, one of Leland’s reliable
vendors, has offered to supply part number KJ37 at a unit price of
$15,000.
1. If Leland purchases the KJ37 units from Scott, the capacity
Leland used to mfg. these parts would be idle. Should Leland
decide to purchase the parts from Scott, the unit cost of KJ37 would
increase (decrease) by what amount?
Leland Mfg.: make or buy
Leland Mfg.: make or buy
• Assume Leland Manufacturing is able to rent out all of its
idle capacity for $25,000 per month. If Leland decides to
purchase the 10 units from Scott Supply, Leland’s monthly
cost for KJ37 would increase (decrease) by what amount?
Leland Mfg.: make or buy
• Assume that Leland Mfg. Does not wish to commit to a
rental agreement but could use its idle capacity to
manufacture another product that would contribute
$52,000 per month. If Leland elects to manufacture KJ37
in order to maintain quality control, what is the net amount
of Leland’s cost from using the space to manufacture part
KJ37.
Chemung: Closing a department
• What is relevant?
– Division contribution - not division
profit
– Traceable fixed costs
– Contribution margin - traceable fixed
costs = division contribution
Chemung: closing a department
Chemung Metals Co. is considering the elimination of its Packaging
Dept. Management has received an offer from an outside firm to
supply all Chemung’s packaging needs. To help her in making the
decision, Chemung’s president has asked the controller for an
analysis of the cost of running Chemung’s Packaging Dept.
Included in that analysis is $9,100 of rent, which represents the
Packaging Dept.’s allocation of the rent on Chemung’s factory.
If the Packaging Dept. is eliminated, the space it used will be
converted to storage space. Currently, Chemung rents storage space
in a nearby warehouse for $11,000 per year. The warehouse rental
would no longer be necessary if the Packaging Dept. were
eliminated.
Chemung: closing a department
• What is the relevant cost of the space that will be
freed up if Chemung closes the dept.?
• If Chemung closes its packaging department, the
department manager will be appointed manager of
the Cutting Dept. The packaging department
manager makes $45,000 per year. To hire a new
Cutting Dept. manager will cost $60,000 per year.
• Is the $45,000 salary relevant?
• Is the $60,000 salary relevant?
Day Street Deli: dropping a
product
Day Street Deli’s owner is disturbed by the poor profit performance of
his ice cream counter. He has prepared the following profit analysis.
Sales
$45,000
Less: Cost of food
20,000
Gross profit
25,000
Less: Operating expenses
Wages of counter personnel
12,000
Paper products
4,000
Utilities (allocated)
2,900
Depr. Of counter equip.
2,500
Depr. Of bldg. (allocated)
4,000
Deli manager’s salary
3,000
Loss on ice cream counter
$(3,400)
Day Street Deli: dropping a
product
Criticize the owner’s analysis
Thursday
• Hanson Manufacturing case.
• What would happen to income if product
103 were dropped? Hanson would lose 103
contribution.
• Also look at the effect of the price change
on total contribution.
Group work
• Answer Super Clean and hand in your
solution.