Week 13, Chap 12 Relevant Information for Special Decisions

Week 13, Chap 12 Relevant Information for Special Decisions Instructor: Michael Booth Cabrillo College

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

Identifying Relevant Costs 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.

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 $100 Labor 120 Overhead* 80 Total $300 Desired Profit 50 Price $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.

Relevant Costs Sunk Costs Opportunity Cost Overview of Concepts

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 Costs An 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 Step 1 Step 2 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.

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 Aside from tax consequences, sunk costs are never relevant. What are sunk costs? Sunk costs result from past decisions that cannot be changed. 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) Expected future Revenue Expected future costs Relevant excess of revenue vs. costs Accumulated historical cost of inventory* Re- Machine Scrap Difference $50,000 $ 5,000 $45,000 30,000 0 30,000 $20,000 $ 5,000 $15,000 $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. Replacement Old Machine Machine Original Cost $ 10,000 $ 8,000 Useful life in year 10 4 Current age in year 6 0 Useful life remaing in yrs 4 10 Accumulated Depreciation $ 6,000 $ - Book Value $ 4,000 N/A Disposal value (in cash) now $ 2,500 NA Disposal 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 Training Cost Items Hotel Facility Relevant? 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 Cost Behavior Product or GS&A 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.

Required Pass Fast, Inc (cont.) 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.

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

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.

Budgeted Cost for Expected Production of 2,000 Printers 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 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. Cost per unit - $658,500 2000 = $329.25

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? Relevant Information for Special 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 If the order is accepted, profitability will increase by $11,800.

Special Order Decision Opportunity 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? Relevant Information for Special 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) Opportunity cost (15,000) Contribution to income $ (3,200) If the order is rejected, profitability will decrease by $3,200.

Special Order Decision Relevance and the Decision Context If Premier can increase income by selling its printers for $250, can the company reduce its normal selling price to $250?

Special Order Decision Relevance and the Decision Context 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? Selling 2,200 Printers for $250 Per Unit 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) Note: Revenue, unit and batch costs increase with number of units

Special Order Decision Qualitative Characteristics Should a company ever reject a special order if the relevant revenues exceed the relevant costs? 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 Decision When 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 Company A. 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 decision Pleasant Toy Company

Pleasant Toy Company Model K Quantity 15,000 Model K 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

Additional Information: OutSourcing Decision Pleasant Toy Company 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 Company A. 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 Quantity 15,000 Model K Avoidable Model K Relevant Avoidable Replacement Avoidable Costs Unit-level material costs $ 6 $ 90,000 $ - Unit-level labor costs $ 20 $ 300,000 $ 300,000 $ 240,000 $ 60,000 Unit-level overhead cost $ 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 cost $ 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)