costacctg13_sm_ch11 - CHAPTER 11 DECISION MAKING AND...

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Unformatted text preview: CHAPTER 11 DECISION MAKING AND RELEVANT INFORMATION 11­1 1. 2. 3. 4. 5. The five steps in the decision process outlined in Exhibit 11­1 of the text are Ident ify the problem and uncertaint ies Obtain informat ion Make predict ions about the future Make decisio ns by choosing among alternat ives Implement the decisio n, evaluate performance, and learn 11­2 Relevant costs are expected future costs that differ among the alternat ive courses o f action being considered. Historical costs are irrelevant because they are past costs and, therefore, cannot differ among alternat ive future courses of action. 11­3 No. Relevant costs are defined as those expected future costs that differ among alternat ive courses o f act ion being considered. Thus, future costs that do not differ amo ng the alternat ives are irrelevant to deciding which alternative to choose. 11­4 Quant itative factors are outcomes that are measured in numerical terms. So me quant itative factors are financial––that is, they can be easily expressed in mo netary terms. Direct materials is an example o f a quant itative financial factor. Qualitat ive factors are outcomes that are difficult to measure accurately in numerical terms. An example is emplo yee morale. 11­5 Two potential problems that should be avo ided in relevant cost analysis are (i) Do not assume all variable costs are relevant and all fixed costs are irrelevant. (ii) Do not use unit­cost data direct ly. It can mis lead decisio n makers because a. it may include irrelevant costs, and b. comparisons of unit costs computed at different output levels lead to erroneous conclusio ns 11­6 No. Some variable costs may not differ amo ng the alternat ives under consideration and, hence, will be irrelevant. Some fixed costs may differ amo ng the alternatives and, hence, will be relevant. 11­7 No. Some of the total unit costs to manufacture a product may be fixed costs, and, hence, will not differ between the make and buy alternatives. These fixed costs are irrelevant to the make­or­buy decisio n. The key co mparison is between purchase costs and the costs that will be saved if the co mpany purchases the co mponent parts from outside plus the addit ional benefits o f using the resources freed up in the next best alternat ive use (opportunit y cost). Furthermore, managers should consider nonfinancial factors such as qualit y and timely delivery when making outsourcing decisio ns. 11­8 Opportunity cost is the contribut ion to inco me that is forgone (rejected) by not using a limited resource in its next­best alternat ive use. 11­9 No. When deciding on the quant it y of inventory to buy, managers must consider both the purchase cost per unit and the opportunit y cost of funds invested in the inventory. For example, the purchase cost per unit may be low when the quant it y o f inventory purchased is large, but the 11­1 benefit of the lower cost may be more than offset by the high opportunit y cost of the funds invested in acquiring and ho lding inventory. 11­10 No. Managers should aim to get the highest contribution margin per unit of the constraining (that is, scarce, limit ing, or crit ical) factor. The constraining factor is what restricts or limits the production or sale of a given product (for example, availabilit y of machine­hours). 11­11 No. For example, if the revenues that will be lo st exceed the costs that will be saved, the branch or business segment should not be shut down. Shutting down will only increase the loss. Allocated costs are always irrelevant to the shut­down decisio n. 11­12 Cost written off as depreciat ion is irrelevant when it pertains to a past cost such as equipment already purchased. But the purchase cost of new equipment to be acquired in the future that will then be wr itten off as depreciat ion is often relevant. 11­13 No. Managers tend to favor the alternat ive that makes their performance look best so they focus on the measures used in the performance­evaluat ion model. If the performance­evaluat ion model does not emphasize maximizing operating inco me or minimizing costs, managers will most likely not choose the alternat ive that maximizes operating income or minimizes costs. 11­14 The three steps in so lving a linear programming problem are (i) Determine the object ive funct ion. (ii) Specify the constraints. (iii) Co mpute the optimal solut ion. 11­15 The text outlines two methods of determining the optimal so lution to an LP problem: (i) Trial­and­error solut ion approach (ii) Graphical so lut ion approach Most LP applicat ions in pract ice use standard software packages that rely on the simplex method to compute the optimal so lut ion. 11­2 11­16 (20 min.) Disposal of assets. 1. This is an unfortunate situation, yet the $75,000 costs are irrelevant regarding the decisio n to remachine or scrap. The only relevant factors are the future revenues and future costs. By ignoring the accumulated costs and deciding on the basis of expected future costs, operating inco me will be maximized (or losses minimized). The difference in favor of remachining is $2,000: (a) (b) Remachine Scrap Future revenues Deduct future costs Operating inco me Difference in favor of remachining $30,000 25,000 $ 5,000 $2,000 $3,000 – $3,000 2. This, too, is an unfortunate situation. But the $100,000 original cost is irrelevant to this decisio n. The difference in relevant costs in favor of rebuilding is $5,000 as fo llows: (a) Replace New truck Deduct current disposal price of exist ing truck Rebuild exist ing truck $105,000 15,000 – $ 90,000 $5,000 (b) Rebuild – – $85,000 $85,000 Difference in favor of rebuilding Note, here, that the current disposal price of $15, 000 is relevant, but the original cost (or book value, if the truck were not brand new) is irrelevant. 11­3 11­17 (20 min.) Relevant and irrelevant costs. 1. Make Relevant costs Variable costs Avo idable fixed costs Purchase price Unit relevant cost $180 20 ____ $200 Buy $210 $210 Dalton Computers should reject Peach’s o ffer. The $30 of fixed costs are irrelevant because they will be incurred regardless o f this decisio n. When comparing relevant costs between the cho ices, Peach’s o ffer price is higher than the cost to continue to produce. 2. Cash operating costs (4 years) Current disposal value of old machine Cost of new machine Total relevant costs Keep $80,000 ______ $80,000 Replace Difference $48,000 $32,000 (2,500) 2,500 8,000 (8,000) $53,500 $26,500 AP Manufacturing should replace the o ld machine. The cost savings are far greater than the cost to purchase the new machine. 11­18 (15 min.) Multiple choice. 1. (b) Special order price per unit Variable manufacturing cost per unit Contribut ion margin per unit = $1.50 ´ 20,000 units = $30,000 increase $1,200,000 $48 9 $57 1,140,000 60,000 25,000 $ 85,000 $6.00 4.50 $1.50 Effect on operating inco me 2. (b) Costs of purchases, 20,000 units ´ $60 Total relevant costs of making: Variable manufacturing costs, $64 – $16 Fixed costs eliminated Costs saved by not making Mult iply by 20,000 units, so total costs saved are $57 ´ 20,000 Extra costs of purchasing outside Minimum overall savings for Reno Necessary relevant costs that would have to be saved in manufacturing Part No. 575 11­4 11­19 (30 min.) Special order, activity­based costing. 1. Award Plus’ operating inco me under the alternatives of accept ing/reject ing the specia l order are: Without One­ With One­ Time Only Time Only Special Order Special Order 7,500 Units 10,000 Units Revenues Variable costs: Direct materials Direct manufacturing labor Batch manufacturing costs Fixed costs: Fixed manufacturing costs Fixed market ing costs Total costs Operating inco me 1 Difference 2,500 Units $250,000 87,500 100,000 12,500 –– –– 200,000 $ 50,000 $1,125,000 262,500 300,000 75,000 275,000 175,000 1,087,500 $ 37,500 2 $1,375,000 350,000 2 400,000 3 87,500 275,000 175,000 1,287,500 $ 87,500 3 1 $262, 500 ´ 10,000 7, 500 $300, 000 ´ 10,000 7, 500 $75,000 + (25 ´ $500) Alternat ively, we could calculate the incremental revenue and the incremental costs of the addit ional 2,500 unit s as fo llows: Incremental revenue $100 ´ 2,500 Incremental direct manufacturing costs Incremental direct manufacturing costs Incremental batch manufacturing costs Total incremental costs Total incremental operating inco me fro m accepting the special order $262,500 ´ 2,500 7,500 $300,000 ´ 2,500 7,500 $500 ´ 25 $250,000 87,500 100,000 12,500 200,000 $ 50,000 Award Plus should accept the one­time­only special order if it has no long­term implicat ions because accept ing the order increases Award Plus’ operating inco me by $50,000. If, however, accepting the special order would cause the regular customers to be dissat isfied or to demand lower prices, then Award Plus will have to trade off the $50,000 gain fro m accept ing the special order against the operating inco me it might lose fro m regular customers. 11­5 2. Award Plus has a capacit y of 9,000 medals. Therefore, if it accepts the special one­time order of 2,500 medals, it can sell only 6,500 medals instead of the 7,500 medals that it current ly sells to existing customers. That is, by accept ing the special order, Award Plus must forgo sales of 1,000 medals to its regular customers. Alternatively, Award Plus can reject the special order and cont inue to sell 7,500 medals to its regular customers. Award Plus’ operating inco me from selling 6,500 medals to regular customers and 2,500 medals under one­time special order follow: Revenues (6,500 ´ $150) + (2,500 ´ $100) 1 1 Direct materials (6,500 ´ $35 ) + (2,500 ´ $35 ) 2 2 Direct manufacturing labor (6,500 ´ $40 ) +(2,500 ´ $40 ) 3 Batch manufacturing costs (130 ´ $500) + (25 ´ $500) Fixed manufacturing costs Fixed market ing costs Total costs Operating inco me 1 $1,225,000 315,000 360,000 77,500 275,000 175,000 1,202,500 $ 22,500 $35 = $262, 500 7, 500 2 $40 = $300,000 7,500 3 Award Plus makes regular medals in batch sizes of 50. To produce 6,500 medals requires 130 (6,500 ÷ 50) batches. Accepting the special order will result in a decrease in operating inco me o f $15,000 ($37,500 – $22,500). The special order should, therefore, be rejected. A more direct approach would be to focus on the incremental effects––the benefits o f accept ing the special order of 2,500 units versus the costs of selling 1,000 fewer units to regular customers. Increase in operating inco me fro m the 2,500­unit special order equals $50,000 (requirement 1). The loss in operating income fro m selling 1,000 fewer units to regular customers equals: Lost revenue, $150 ´ 1,000 Savings in direct materials costs, $35 ´ 1,000 Savings in direct manufacturing labor costs, $40 ´ 1,000 Savings in batch manufacturing costs, $500 ´ 20 Operating inco me lost $(150,000) 35,000 40,000 10,000 $ (65,000) Accepting the special order will result in a decrease in operating inco me of $15,000 ($50,000 – $65,000). The special order should, therefore, be rejected. 3. Award Plus should not accept the special order. Increase in operating inco me by selling 2,500 units under the special order (requirement 1) Operating inco me lost from exist ing customers ($10 ´ 7,500) Net effect on operating inco me of accept ing special order The special order should, therefore, be rejected. $ 50,000 (75,000) $(25,000) 11­6 11­20 (30 min.) Make versus buy, activity­based costing. 1. The expected manufacturing cost per unit of CMCBs in 2009 is as fo llows: Total Manufacturing Manufacturing Costs of CMCB Cost per Unit (1) (2) = (1) ÷ 10,000 $1,700,000 $170 450,000 45 120,000 12 320,000 800,000 $3,390,000 32 80 $339 Direct materials, $170 ´ 10,000 Direct manufacturing labor, $45 ´ 10,000 Variable batch manufacturing costs, $1,500 ´ 80 Fixed manufacturing costs Avo idable fixed manufacturing costs Unavo idable fixed manufacturing costs Total manufacturing costs 2. The fo llowing table ident ifies the incremental costs in 2009 if Svenson (a) made CMCBs and (b) purchased CMCBs from Minton. Total Incremental Costs Incremental Items Make Buy Cost of purchasing CMCBs fro m Minton $3,000,000 Direct materials $1,700,000 Direct manufacturing labor 450,000 Variable batch manufacturing costs 120,000 Avo idable fixed manufacturing costs 320,000 Total incremental costs $2,590,000 $3,000,000 Difference in favor of making $410,000 Per­Unit Incremental Costs Make Buy $300 $170 45 12 32 $259 $300 $41 Note that the opportunit y cost of using capacit y to make CMCBs is zero since Svenson would keep this capacit y idle if it purchases CMCBs from Minton. Svenson should cont inue to manufacture the CMCBs internally since the incremental costs to manufacture are $259 per unit compared to the $300 per unit that Minton has quoted. Note that the unavo idable fixed manufacturing costs of $800,000 ($80 per unit) will cont inue to be incurred whether Svenson makes or buys CMCBs. These are not incremental costs under either the make or the buy alternat ive and hence, are irrelevant. 11­7 3. Svenson should cont inue to make CMCBs. The simplest way to analyze this problem is to recognize that Svenson would prefer to keep any excess capacit y idle rather than use it to make CB3s. Why? Because expected incremental future revenues fro m CB3s, $2,000,000, are less than expected incremental future costs, $2,150,000. If Svenson keeps its capacit y idle, we know fro m requirement 2 that it should make CMCBs rather than buy them. An important point to note is that, because Svenson forgoes no contribut ion by not being able to make and sell CB3s, the opportunit y cost of using its facilit ies to make CMCBs is zero. It is, therefore, not forgoing any pro fits by using the capacit y to manufacture CMCBs. If it does not manufacture CMCBs, rather than lose money on CB3s, Svenson will keep capacit y idle. A longer and more detailed approach is to use the total alternat ives or opportunit y cost analyses shown in Exhibit 11­7 of the chapter. Choices for Svenson Make CMCBs Buy CMCBs Buy CMCBs and Do Not and Do Not and Make Relevant Items Make CB3s Make CB3s CB3s TOTAL­ALTERNATIVES APPROACH TO MAKE­OR­BUY DECISIONS Total incremental costs of making/buying CMCBs (from requirement 2) Excess of future costs over future revenues from CB3s Total relevant costs $2,590,000 0 $2,590,000 $3,000,000 0 $3,000,000 $3,000,000 150,000 $3,150,000 Svenson will minimize manufacturing costs by making CMCBs. OPPORTUNITY­COST APPROACH TO MAKE­OR­BUY DECISIONS Total incremental costs of making/buying CMCBs (from requirement 2) $2,590,000 $3,000,000 Opportunity cost: profit contribut ion forgone because capacit y will not * * be used to make CB3s 0 0 Total relevant costs $2,590,000 $3,000,000 * $3,000,000 0 $3,000,000 Opportunity cost is 0 because Svenson does not give up anything by not making CB3s. Svenson is best off leaving the capacity idle (rather than manufacturing and selling CB3s). 11­8 11­21 (10 min.) Inventory decision, opportunity costs. 1. Unit cost, orders of 20,000 Unit cost, order of 240,000 (0.96 ´ $9.00) Alternatives under consideration: (a) Buy 240,000 units at start of year. (b) Buy 20,000 units at start of each mo nth. Average investment in inventory: (a) (240,000 ´ $8.64) ÷ 2 (b) ( 20,000 ´ $9.00) ÷ 2 Difference in average invest ment $9.00 $8.64 $1, 036,800 90,000 $ 946,800 Opportunity cost of interest forgone fro m 240,000­unit purchase at start of year = $946,800 ´ 0.10 = $94,680 2. No. The $94,680 is an opportunit y cost rather than an incremental or outlay cost. No actual transact ion records the $94,680 as an entry in the accounting system. 3. The fo llowing table presents the two alternat ives: Alternative A: Alternative B: Purchase Purchase 240,000 20,000 spark plugs at spark plugs beginning of at beginning year of each month Difference (1) (2) (3) = (1) – (2) Annual purchase­order costs (1 ´ $200; 12 ´ $200) Annual purchase ( incremental) costs (240,000 ´ $8.64; 240,000 ´ $9) Annual interest inco me that could be earned if invest ment in inventory were invested (opportunit y cost) (10% ´ $1,036,800; 10% ´ $90,000) Relevant costs $ 200 2,073,600 $ 2,400 2,160,000 $ (2,200) (86,400) 103,680 $2,177,480 9,000 $2,171,400 94,680 $ 6,080 Column (3) indicates that purchasing 20,000 spark plugs at the beginning o f each mo nth is preferred relative to purchasing 240,000 spark plugs at the beginning o f the year because the opportunit y cost of ho lding larger inventory exceeds the lower purchasing and ordering costs. If other incremental benefit s of ho lding lower inventory such as lower insurance, materials handling, storage, obsolescence, and breakage costs were considered, the costs under Alternative A would have been higher, and Alternat ive B would be preferred even more. 11­9 11­22 (20–25 min.) Relevant costs, contribution margin, product emphasis. 1. Cola $18.80 14.20 $ 4.60 Lemonade $20.00 16.10 $ 3.90 Punch $27.10 20.70 $ 6.40 Natural Orange Juice $39.20 30.20 $ 9.00 Selling price Deduct variable cost per case Contribut ion margin per case 2. The argument fails to recognize that shelf space is the constraining factor. There are only 12 feet of front shelf space to be devoted to drinks. Sexton should aim to get the highest daily contribution margin per foot of front shelf space: Natural Orange Juice $ 9.00 ´ 5 Contribut ion margin per case Sales (number of cases) per foot of shelf space per day Daily contribut ion per foot of front shelf space 3. Cola $ 4.60 ´ 25 Lemonade $ 3.90 ´ 24 Punch $ 6.40 ´ 4 $115.00 $93.60 $25.60 $45.00 The allocation that maximizes the daily contribut ion fro m soft drink sales is: Daily Contribution per Foot of Total Contribution Front Shelf Space Margin per Day $115.00 $ 690.00 93.60 374.40 45.00 45.00 25.60 25.60 $1,135.00 Cola Lemo nade Natural Orange Juice Punch Feet of Shelf Space 6 4 1 1 The maximum of six feet of front shelf space will be devoted to Cola because it has the highest contribution margin per unit o f the constraining factor. Four feet of front shelf space will be devoted to Lemonade, which has the second highest contribut ion margin per unit of the constraining factor. No more shelf space can be devoted to Lemonade since each o f the remaining two products, Natural Orange Juice and Punch (that have the second lowest and lowest contribut ion margins per unit o f the constraining factor) must each be given at least one foot of front shelf space. 11­10 11­23 (10 min.) Selection of most profitable product. Only Model 14 should be produced. The key to this problem is the relat ionship of manufacturing overhead to each product. Note that it takes twice as long to produce Model 9; machine­hours for Model 9 are twice that for Model 14. Management should choose the product mix t hat maximizes operating inco me for a given production capacit y (the scarce resource in this situation). In this case, Model 14 will yield a $9.50 contribution to fixed costs per machine hour, and Model 9 will yield $9.00: Model 9 Selling price Variable costs per unit (total cost – FMOH) Contribut ion margin per unit Relative use of machine­hours per unit of product Contribut ion margin per machine hour $100.00 82.00 $ 18.00 ÷ 2 $ 9.00 Model 14 $70.00 60.50 $ 9.50 ÷ 1 $ 9.50 11­24 (20 min.) Which base to close, relevant­cost analysis, opportunity costs. The future outlay operating costs will be $400 millio n regardless o f which base is clo sed, given the addit ional $100 millio n in costs at Everett if Alameda is closed. Further, one of the bases will permanent ly remain open while the other will be shut down. The only relevant revenue and cost comparisons are a. $500 millio n fro m sale o f the Alameda base. Note that the historical cost of building the Alameda base ($100 millio n) is irrelevant. Note also that future increases in the value o f the land at the Alameda base is also irrelevant. One of the bases must be kept open, so if it is decided to keep the Alameda base open, the Defense Depart ment will not be able to sell this land at a future date. b. ...
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