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DECISION MAKING
Key Terms and Concepts to Know
Relevance: Relevant costs and benefits are those that differ among alternatives Total approach vs. differential approach and why relevant costs must be isolated. Difference between costs that are avoidable and those that are not avoidable. Avoidable costs are those that can be eliminated (in whole or in part) by choosing one alternative over another in a decision Sunk costs, costs that has already been incurred and that cannot be changed by any decision made now or in the future, are never relevant Future revenues and costs that will not change by choosing one alternative over another in a decision are never relevant How and why some fixed costs (common fixed costs) need to be allocated, and the problems inherit in the allocation process.
Constraints: Limitations under which a company must operate, such as limited available machine time or raw materials, which restricts the company’s ability to satisfy demand. Constraints or bottlenecks limit a company’s ability to grow and limit the total output of the entire system.
Opportunity Costs: Opportunity costs are not recorded in the general ledger. Opportunity costs are factors in the decision-making process because they differ among alternatives.
Key Topics to Know
Companies make many decisions which require relevant information on a timely basis. Some of these decisions include: o Accepting or not accepting a special order, a one-time sales order that is not considered part of the company’s normal ongoing business. o Dropping or retaining a product line or other business segment o Make or buy decisions, concerning whether an item should be produced internally or purchased from an outside supplier. o The most profitable use of a constrained resource to maximize the company’s total contribution margin. o Sell or process further decisions. Allocated common fixed costs, as noted in other chapters, can distort profitability analyses. Allocating these costs is generally an arbitrary process. These costs tend to be unaffected by the decisions covered in this chapter and therefore are the same before and after the decision has been made. Problems may state how allocated fixed costs will change. If that is the case, the change in the allocated fixed costs should be included in the solution.
Relevant Costs
Example #
Birmingham Company normally runs at capacity and the Model CY1000 machine is the company’s production constraint. Management is considering purchasing a new machine, Model CZ4000 and selling the CY1000. The CZ4000 is more efficient and can produce 20% more units than the old one. If the new machine is purchased, there should be a reduction in maintenance costs. The company will need to borrow money in order to purchase the CZ4000. The increase in volume will require increases in fixed selling expense, but general administrative expenses will remain unchanged.
Required: For each cost listed below, determine whether the cost is relevant or irrelevant to the decision to replace the CY1000.
a) Sales Revenue b) Direct materials c) Direct labor d) Variable manufacturing overhead e) Rent on the factory building f) Janitorial salaries
b) he company has 500 units of this product left over from last year that are vastly inferior to the current model. The units must be sold through regular channels at reduced prices. What unit cost is relevant for establishing a minimum selling price for these units? Explain.
Solution # a) Selling price $12. Direct materials $2. Direct labor 3. Variable manufacturing overhead. Variable selling and administrative expense 1. Total variable expenses 7. Contribution margin 4. Units sold 2, Total contribution margin $9,
b) The relevant cost is $1.50 (the variable selling and administrative costs). All other variable costs are sunk, since the units have already been produced. The fixed costs would not be relevant, since they will not be affected by the sale of leftover units.
Dropping or Retaining a Segment
For this decision, the question is whether avoiding traceable and perhaps common fixed costs will offset the lost contribution margin from the dropped segment. Dropping a segment may also affect the profitability of some or all of the remaining segments. These effects must be included in the analysis of the decision.
Example #
B & B Inc., a retailing company has two departments, X and Y. A recent monthly contribution format income state for the company follows.
X Y Total Sales $3,000,000 $1,000,000 $4,000, Variable expenses 900,000 400,000 1,300, Contribution margin 2,100,000 600,000 2,700,
Fixed expenses 1,400,000 800,000 2,200, Operating income (loss) $700,000 ($200,000) $500,
A study indicates that $340,000 of the fixed expenses being charged to Y are sunk costs or allocated costs that will continue even if Y is dropped. In addition the elimination of Y will result in a 10% decrease in the sales of X.
Required: If Department Y is discontinued, will this be a positive move or a negative move for the company as a whole?
Solution #
Contribution margin lost if Y is dropped:
Department Y contribution margin lost ($600,000) Department X contribution margin lost (210,000) Total contribution margin lost (810,000) Avoidable fixed costs 460, Decrease in operating income ($350,000)
Make or Buy
Make or buy decisions do not involve revenue; rather they are least-cost decisions: is it cheaper to make the product in-house or to contract it out to a supplier? For these decisions, common allocated fixed costs are rarely relevant.
Buying the product from a supplier may make manufacturing and/or warehouse space available for an alternative, profitable use. The potential profits are opportunity costs that are added to the costs of manufacturing the product in-house.
Example #
For many years Lansing Company has purchased the starters that it installs in its standard line of garden tractors. Due to a reduction in output, the company has idle capacity that could be used to produce the starters. The chief engineer has recommended against this move, however, pointing out that the cost to produce the starters would be greater than the current $10.00 per unit purchase price. The company’s unit product cost, based on a production level of 60,000 starters per year, is as follows:
Constrained Resources
A constraint is a limitation; therefore a constrained resource is one that is scare or has limited availability. Since the company’s objective is to maximize profit, the constrained resource must be used in a way that allows the company to achieve this objective.
Each time a unit of the constrained resource is used, the contribution it makes toward the company’s profitability must be maximized. The contribution toward profit is measured by the contribution margin per unit of constrained resource. Selling the products with the highest selling prices per unit will maximize sales but not necessarily profits because both variable costs per unit and the amount of the constrained resource have not been considered. Maximizing selling price per unit – variable costs per unit = contribution margin per unit is better but the amount of the constrained resource still has not been considered. Therefore contribution margin per unit of constrained resource is the proper measurement of profitability as it considers all three factors.
Example #
Oregon Company produces three products, X, Y, and Z. Data concerning the three products are as follows: X Y Z Selling price $80.00 $56.00 $70. Variable expenses: Direct materials 24.00 15.00 9. Direct labor 14.00 13.00 15. Other variable expenses 10.00 14.00 25. Contribution margin $32.00 $14.00 $21.
Demand for the company’s products is very strong, with far more order each month than the company can produce with the available raw materials. The same material is used in each product. The material cost $3 per pound, with a maximum of 5, pounds available each month.
Required: In which order should the company produce X, Y and Z?
Solution #
The company should accept orders first for Z, second for X and third for Y.
X Y Z Direct materials cost $24.00 $15.00 $9. Cost per pound $3.00 $3.00 $3. Direct material pounds per unit 8.00 5.00 3. Contribution margin $32.00 $14.00 $21. Contribution margin per pound $4.00 $2.80 $7.
Sell or Process Further Decisions
In some industries, multiple products can be produced for a single raw material. Typically these products emerge after some amount of processing has been done to the raw material. For example, a lumber mill will process the basic raw material, logs, up to the point at which they have been cut into lumber. Certainly the rough-cut lumber can be sold as-is, but it could also be processed further into consumer-ready products. The sawdust and shavings could also be sold as-is or processed further into products such as particleboard. Costs incurred in processing the basic raw materials up to the point where the separate products emerge are called joint costs. The point where these separate or joint products emerge is called the split-off point. At the split-off point, the products are referred to as intermediate products. They are not finished products because further processing could occur. The additional processing occurs at an additional cost and generates additional sales revenue. The decision whether to process further is based on the incremental profit after the split off point.
The question is whether the additional incremental revenues earned justify the additional incremental processing costs incurred to produce the finished products. The joint costs incurred up to the split-off point are not relevant to this decision as they would have been incurred regardless of the decision made.
Practice Problems
Practice Problem #
Jackson Company is now making a small part used in one of its products. The unit costs of producing the part internally are:
Direct materials $15. Direct labor 10. Variable manufacturing overhead 2. Fixed manufacturing overhead, traceable 4. Fixed manufacturing overhead, allocated 5. Unit product cost $36.
Depreciation of special equipment represents 75% of the traceable fixed manufacturing overhead cost with supervisory salaries representing the balance. The supervisory salaries could be avoided if production of the part were discontinued. An outside supplier has offered to sell the part to Jackson Company for $30 each, based on an order of 5,000 parts per year.
Required: Should Jackson Company accept this offer?
Practice Problem #
Tampa Company makes two models of its hair dryer. The copper-winding machine has been the production constraint as it is useable only 9,600 minutes per month. Data concerning these two products appear below:
Standard Premium Selling price $14.00 $20. Variable cost .00 8. Contribution margin 9.00 12. Machine time per unit .5 minutes .6 minutes Monthly demand 12,000 units 8,000 units
Required: a) Does product demand really exceed machine capacity? b) Determine the contribution margin per minute for each product. c) How many units of each product should be made to maximize net operating income?
Practice Problem #
Moo Milk makes the 1-gallon plastic milk jugs used to package its premium goat’s milk. The company has been approached by a plastic molding company with an offer to produce the milk jugs at a cost of $14.00 per thousand jugs. Moo’s president believes the company should continue to produce the jugs and the plant manager has recommended accepting the offer because the cost to produce the jugs is greater than the purchase price. The company’s cost to produce one thousand jugs is as follows:
Direct materials $4. Direct labor 2. Variable manufacturing overhead 3. Fixed manufacturing overhead, traceable 3. Fixed manufacturing overhead, common 2. Total production cost $15.
One-half of the traceable fixed manufacturing costs represent supervisory salaries and other costs that can be eliminated if the milk jugs are purchased. The balance of the traceable fixed manufacturing costs is depreciation of manufacturing equipment that has no resale value. Some of the space being used to produce the milk jugs could be used to store empty jugs, eliminating a rented warehouse and reducing common fixed costs by 20%. The rest of the space could be rented to another company for $30,000 per year. Moo Milk produces 10,000,000 milk jugs per year.
Required: Should Moo Milk make or buy the milk jugs?
Practice Problem #
Teton Tents makes backpacking tents. It has the capacity to produce 10,000 tents per year and currently is producing and selling 7,000 tents. Normal selling price for a tent is $470. Unit-level costs are $100 for direct materials, $200 for direct labor, and $25 for other manufacturing costs. Facility-level costs of $80 are allocated to each tent. Teton has received a special order for 1,500 tents at $340 each.
Required: How much income will Teton make on the special order?
Practice Problem #
The Mendoza Company is trying to decide whether to replace a packing machine that it uses to pack pasta into serving size packages. The following information is available:
Current Machine
New Machine Original cost $13,000 $8, Accumulated depreciation 8, Annual operating costs 2,000 500 Current salvage value 2, Salvage value in 5 years 500 500
Required: a) Compute the increase or decrease in total net income over the five-year period if the company chooses to buy the new machine. b) Compute the impact on the company's net income in the first year if the current machine is replaced. Do not take depreciation into account.
Practice Problem #
Cheeks Company has two divisions whose most recent income statements are shown below:
Commercial Division
Residential Division Unit sales 10,000 2, Sales $800,000 $200, Cost of goods sold: Production costs 350,000 120, Depreciation expense, equipment 150,000 50, Gross margin $300,000 $30, Operating expenses: Traceable selling and administrative costs 80,000 20, Corporate office expenses 25,000 15, Net Income (Loss) $195,000 ($5,000)
Required: Compute the impact on profit if the Residential Division is eliminated.
Practice Problem #
A company has already incurred $93,000 cost in partially producing its three products. Their selling prices when partially and fully processed are shown in the table below with the additional costs necessary to finish their processing.
Product
Unfinished Selling Price
Finished Selling Price
Further Processing Costs A $31.27 $62.37 $33. B 42.56 96.11 49. C 89.01 102.72 17.
Required: Based on this information, should any products be processed further?
- An out-of-pocket cost requires a current and/or future outlay of cash. True False
- The concept of incremental cost is the same as the concept of differential cost. True False
- The decision to accept an additional volume of business should be based on a comparison of the revenue from the additional business with the sunk costs of producing that revenue. True False
- Contribution margin lost from a decline in sales is an opportunity cost. True False
- When considering whether a business segment should be eliminated, unavoidable expenses are amounts that will continue even if a given segment is eliminated. True False
- If accepting additional business would cause existing sales to decline, the offer should always be declined. True False
- If a company has the capacity to produce either 10,000 units of Product X or 10,000 units of Product Y, and the markets for both products are unlimited, the company should commit 100% of its capacity to the product that has the higher contribution margin. True False
- Joint costs should be added to incremental costs to determine whether an intermediate product should be processed further. True False
- Revenues at the split-off point are not relevant in the decision to process further. True False
Multiple Choice Questions
1. Which cost is not relevant to the decision whether to purchase a new chocolate
dipping machine or continue using the old one: a) The cost of the new machine b) Lower maintenance costs for the new machine c) The cost of the old machine d) Additional training required for operating the new machine
2. A cost that does not affect a decision is called an
a) opportunity cost b) incremental cost c) avoidable cost d) irrelevant cost
3. Costs that change between alternatives are called
a) fixed costs. b) opportunity costs. c) relevant costs. d) sunk costs.
4. A cost incurred in the past that cannot be changed by any future^ action is:
a) opportunity cost b) sunk cost c) relevant cost d) avoidable cost
5. Which statement is true about relevant costs in incremental analysis?
a) All costs are relevant if they change between alternatives b) Only fixed costs are relevant c) Only variable costs are relevant d) Relevant costs should be ignored
6. Canada Inc.^ expands^ its capacity to accept a special^ order.^ It^ is likely^ that:
a) Unit variable costs will increase b) Fixed costs will not be relevant c) Both variable and fixed costs will be relevant d) The company should accept the order
11. Which one of the following does^ not^ affect a make-or-buy decision?
a) Variable manufacturing costs b) Opportunity costs c) Incremental revenue d) Direct labor
12. Wishnell Toys can make 1,000 toy robots with the following costs:
Direct materials $70, Direct labor 26, Variable overhead 15, Fixed overhead 15, The company can purchase the 1,000 robots externally for $120,000. The avoidable fixed costs are $5,000 if the units are purchased externally. What is the cost savings if the company makes the robots? a) $1, b) $5, c) $10, d) $4,
13. Which decision will involve no incremental revenues?
a) Make-or-buy b) Drop a product line c) Accept a special order d) Additional processing
The next 3 questions refer to the following information: Abel Company produces three versions of baseball bats: wood, aluminum, and hard rubber. A segmented income statement for a recent period follows:
Wood Aluminum
Hard Rubber Total Sales $500,000 $200,000 $65,000 $765, Variable Expenses 325,000 140,000 58,000 523, Contribution Margin 175,000 60,000 7,000 242, Fixed Expenses 75,000 35,000 22,000 132, Operating Income $100,000 $25,000 ($15,000) $110,
Assume none of the fixed expenses for the hard rubber line are avoidable.
14. What will be total net income if the^ hard rubber^ line is dropped?
a) $125, b) $103, c) $105, d) $140,
15. Assume all of the fixed expenses for the hard rubber^ line are avoidable. What
will be total net income if that line is dropped? a) $125, b) $103, c) $105, d) $140,
16. If the total net income after dropping the hard rubber line is $105,000, hard
rubber’s avoidable fixed expenses were a) $20,000. b) $2,000. c) $7,000. d) $5,000.
17. North Division has the following information:
Sales $900, Variable Expenses 480 , Fixed Expenses 465 ,
If this division is eliminated, the fixed expenses will be allocated to the company’s other divisions. What is the incremental effect on net income if the division is dropped? a) $45,000 increase b) $465,000 decrease c) $420,000 decrease d) $435,000 increase
18. A company decided to replace an old machine with a new machine. Which of
the following is not considered in the incremental analysis?
a) Annual operating cost of the new equipment b) Annual operating cost of the old equipment c) Net cost of the new equipment d) Book value of the old equipment
