Chapter 5 - Relevant Costing.pptx - 10-1 Relevant Costing...

This preview shows page 1 out of 100 pages.

Unformatted text preview: 10-1 Relevant Costing Chapter 5 Prof Caroline Maranan 10-2 Learning Objective 10-1 Identify relevant and irrelevant costs and benefits in a decision. 10-3 Relevant Costs and Benefits A relevant cost is a cost that differs between alternatives. A relevant benefit is a benefit that differs between alternatives. 10-4 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. Two broad categories of costs are never relevant in any decision. They include: Sunk costs. A future cost that does not differ between the alternatives. 10-5 Keys to Successful Decision-Making 1. Focus only on relevant costs (also called avoidable costs, differential costs, or incremental costs) and relevant benefits (also called differential benefits or incremental benefits). 2. Ignore everything else including sunk costs and future costs and benefits that do not differ between the alternatives. 10-6 Different Costs for Different Purposes Costs that are relevant in one decision situation may not be relevant in another context. Thus, in each decision situation, the manager must examine the data at hand and isolate the relevant costs. 10-7 Identifying Relevant Costs Cynthia, Cynthia, a Boston student, is considering visiting her friend in New York. She can drive or take the train. By car, it is 230 miles to her friend’s friend’s apartment. apartment. She She is is trying trying to to decide decide which which alternative alternative is is less less expensive expensive and and has has gathered gathered the the following information. information. $45 $45 per per month month ×× 88 months months $2.70 $2.70 per per gallon gallon ÷÷ 27 27 MPG MPG $24,000 $24,000 cost cost –– $10,000 $10,000 salvage salvage value value ÷÷ 55 years years 10-8 Identifying Relevant Costs 10-9 Identifying Relevant Costs Which costs and benefits are relevant in Cynthia’s decision? (1) The cost of the car is a sunk cost and is not relevant to the current decision. (3) The annual cost of insurance is not relevant. It will remain the same if she drives or takes the train. (2) However, the cost of gasoline is clearly relevant if she decides to drive. If she takes the train, the cost would not be incurred, so it varies depending on the decision. 10-10 Identifying Relevant Costs Which costs and benefits are relevant in Cynthia’s decision? (4) The cost of maintenance and repairs is relevant. In the long-run these costs depend upon miles driven. (5)The monthly school parking fee is not relevant because it must be paid if Cynthia drives or takes the train. At this point, we can see that some of the average cost of $0.619 per mile are relevant and others are not. 10-11 Identifying Relevant Costs Which costs and benefits are relevant in Cynthia’s decision? (7) The decline in resale value due to additional miles is a relevant cost. (8) The round-trip train fare is clearly relevant. If she drives the cost can be avoided. (9) Relaxing on the train is relevant even though it is difficult to assign a dollar value to the benefit. (10) The kennel cost is not relevant because Cynthia will incur the cost if she drives or takes the train. 10-12 Identifying Relevant Costs Which costs and benefits are relevant in Cynthia’s decision? (13) The cost of parking in New York is relevant because it can be avoided if she takes the train. (11-12) The benefits of having a car in New York and the problems of finding a parking space are both relevant but are difficult to assign a dollar amount. 10-13 Identifying Relevant Costs From a financial standpoint, Cynthia would be better off taking the train to visit her friend. Some of the non-financial factors may influence her final decision. 10-14 Total and Differential Cost Approaches The management of a company is considering a new labor saving 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 $ $ 10-15 Total and Differential Cost Approaches As you can see, the only costs that differ between the alternatives are the direct labor costs savings and the increase in fixed rental costs. Current Situation $ 200,000 Situation With New Machine $ 200,000 Sales (5,000 units @ $40 per unit) Less variable expenses: Direct materials (5,000 @ $14 per unit) 70,000 We canunits efficiently analyze the decision 70,000 by Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 looking at the different costs and revenues Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 and arrive at the same 120,000 solution 105,000 Total variable expenses Contribution margin 80,000 95,000 Less fixed expense: Other 62,000 62,000 Rent on new machine 3,000 Total fixed expenses 62,000 65,000 Net operating income $ 18,000 $ 30,000 . Differential Costs and Benefits 15,000 15,000 (3,000) (3,000) 12,000 10-16 Total and Differential Cost Approaches Using the differential approach is desirable for two reasons: 1. Only rarely will enough information be available to prepare detailed income statements for both alternatives. 2. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical. 10-17 Learning Objective 10-2 Prepare an analysis showing whether a product line or other business segment should be added or dropped. 10-18 Adding/Dropping Segments One of the most important decisions managers make is whether to add or drop a business segment. Ultimately, a decision to drop an old segment or add a new one is going to hinge primarily on the impact the decision will have on net operating income. To assess this impact, it is necessary to carefully analyze the costs. 10-19 Adding/Dropping Segments Due to the declining popularity of digital watches, Lovell Company’s digital watch line has not reported a profit for several years. Lovell is considering discontinuing this product line. 10-20 A Contribution Margin Approach DECISION RULE Lovell should drop the digital watch segment only if its profit would increase. Lovell will compare the contribution margin that would be lost to the costs that would be avoided if the line was to be dropped. 10-21 Adding/Dropping Segments Segment Income Statement Digital Watches Sales Less: variable expenses Variable manufacturing costs Variable shipping costs Commissions Contribution margin Less: fixed expenses General factory overhead Salary of line manager Depreciation of equipment Advertising - direct Rent - factory space General admin. expenses Net operating loss $ 500,000 $ 120,000 5,000 75,000 $ 60,000 90,000 50,000 100,000 70,000 30,000 200,000 $ 300,000 400,000 $ (100,000) 10-22 Adding/Dropping Segments Segment Income Statement Digital Watches Sales $ 500,000 Less: expenseshas An investigation Anvariable investigation has revealed revealed that that the the fixed fixed Variable manufacturing costs and $ 120,000 general factory overhead fixed general general factory overhead and fixed general Variable shipping costs 5,000 administrative expenses be by administrative expenses will will not not be affected affected by Commissions 75,000 200,000 dropping the digital Contribution margin 300,000 dropping the digital watch watch line. line. The The fixed fixed$ general general Less: fixed overhead expenses factory factory overhead and and general general administrative administrative General factory overhead $ 60,000 expenses assigned to this product would be expenses Salary of lineassigned manager to this product 90,000 would be reallocated to reallocated to other other product product lines. Depreciation of equipment 50,000lines. Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 400,000 Net operating loss $ (100,000) 10-23 Adding/Dropping Segments Segment Income Statement Digital Watches Sales $ 500,000 Less: variable expenses The equipment used manufacture The equipment used to to manufacture Variable manufacturing costs $ 120,000 digital watches has Variable costs digitalshipping watches has no no resale resale5,000 Commissions 200,000 value value or or alternative alternative use. use. 75,000 Contribution margin $ 300,000 Less: fixed expenses General factory overhead $ 60,000 Salary of line manager 90,000 Should retain Should Lovell Lovell50,000 retain or or drop drop Depreciation of equipment Advertising - direct the 100,000 segment? the digital digital watch watch segment? Rent - factory space 70,000 General admin. expenses 30,000 400,000 Net operating loss $ (100,000) 10-24 A Contribution Margin Approach Contribution Margin Solution Contribution margin lost if digital watches are dropped Less fixed costs that can be avoided Salary of the line manager $ 90,000 Advertising - direct 100,000 Rent - factory space 70,000 Net disadvantage RRe ettaai inn $ (300,000) 260,000 $ (40,000) 10-25 Comparative Income Approach The Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment. Let’s look at this second approach. 10-26 IfIf the the digital digital watch watch line line is is dropped, dropped, the the company company loses loses $300,000 $300,000 in in contribution contribution margin. margin. 10-27 On On the the other other hand, hand, the the general general factory factory overhead overhead would would be be the the same same under under both both alternatives, alternatives, so so itit is is irrelevant. irrelevant. 10-28 Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Difference Sales $ 500,000 $ $ (500,000) Less variable expenses: The salary of of the the product product- line line Manufacturing expenses The salary120,000 120,000 manager Shipping 5,000disappear, - so 5,000 manager would would disappear, so Commissions 75,000 75,000 itit is relevant to the decision. is relevant to the decision. Total variable expenses 200,000 200,000 Contribution margin 300,000 (300,000) Less fixed expenses: General factory overhead 60,000 60,000 Salary of line manager 90,000 90,000 Depreciation 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 Total fixed expenses 400,000 Net operating loss $ (100,000) 10-29 Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Difference Sales $ 500,000 $ $ (500,000) Less variable expenses: is The depreciation that The depreciation is aa sunk sunk cost. cost. Also, Also, remember remember that Manufacturing expenses 120,000 120,000 the equipment has no resale value or alternative use, the equipment has no resale value or alternative use, Shipping 5,000 5,000 so depreciation so the the equipment equipment and and the the75,000 depreciation expense Commissions -expense 75,000 Total variable expenses 200,000 to 200,000 associated with associated with itit are are irrelevant irrelevant to the the decision. decision. Contribution margin 300,000 (300,000) Less fixed expenses: General factory overhead 60,000 60,000 Salary of line manager 90,000 90,000 Depreciation 50,000 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 Total fixed expenses 400,000 Net operating loss $ (100,000) 10-30 Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Difference Sales $ 500,000 $ $ (500,000) Less variable expenses: Manufacturing expenses 120,000 120,000 The Shipping 5,000 comparative 5,000 The complete complete comparative Commissions 75,000 75,000 income statements reveal that income statements reveal that Total variable expenses 200,000 200,000 Lovell of Lovell would would earn $40,000 $40,000 of (300,000) Contribution margin 300,000earn Less fixed expenses: additional additional profit profit by by retaining retaining the the General factory overhead 60,000 60,000 digital watch line. digital watch line. Salary of line manager 90,000 90,000 Depreciation 50,000 50,000 Advertising - direct 100,000 100,000 Rent - factory space 70,000 70,000 General admin. expenses 30,000 30,000 Total fixed expenses 400,000 140,000 260,000 Net operating loss $ (100,000) $ (140,000) $ (40,000) 10-31 Beware of Allocated Fixed Costs Why should we keep the digital watch segment when it’s showing a $100,000 loss? 10-32 Beware of Allocated Fixed Costs The answer lies in the way we allocate common fixed costs to our products. 10-33 Beware of Allocated Fixed Costs Including unavoidable common fixed costs makes the product line appear to be unprofitable. Our allocations can make a segment look less profitable than it really is. 10-34 Alternatively, Contribution Margin PXX Less: Avoidable Fixed Costs and Expense (XX) Controllable Segment Margin PXX If the Controllable Segment Margin is negative, Discontinue/Drop Segment, because if the Segment/Division is dropped, the loss is eliminated and the overall profit of the enterprise will increase by the same amount. 10-35 Learning Objective 10-3 Prepare a make or buy analysis. 10-36 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. 10-37 The Make or Buy Decision: An Example Essex Company manufactures part 4A that is used in one of its products. The unit product cost of this part is: Direct materials Direct labor Variable overhead Depreciation of special equip. Supervisor's salary General factory overhead Unit product cost $ 9 5 1 3 2 10 $ 30 10-38 The Make or Buy Decision The special equipment used to manufacture part 4A has no resale value. The total amount of general factory overhead, which is allocated on the basis of direct labor hours, would be unaffected by this decision. The $30 unit product 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 Essex make or buy part 4A? 10-39 The Make or Buy Decision The The avoidable avoidable costs costs associated associated with with making making part part 4A 4A include include direct direct materials, materials, direct direct labor, labor, variable variable overhead, overhead, and and the the supervisor’s supervisor’s salary. salary. 10-40 The Make or Buy Decision The The depreciation depreciation of of the the special special equipment equipment represents represents aa sunk sunk cost. cost. The The equipment equipment has has no no resale resale value, value, thus thus its its cost cost and and associated associated depreciation depreciation are are irrelevant irrelevant to to the the decision. decision. 10-41 The Make or Buy Decision Not Not avoidable; avoidable; irrelevant. irrelevant. IfIf the the product product is is dropped, dropped, itit will will be be reallocated reallocated to to other other products. products. 10-42 The Make or Buy Decision Should we make or buy part 4A? Given that the total avoidable costs are less than the cost of buying the part, Essex should continue to make the part. 10-43 Opportunity Cost An opportunity cost is the benefit that is foregone as a result of pursuing some course of action. Opportunity costs are not actual cash outlays and are not recorded in the formal accounts of an organization. If Essex had an alternative use for the capacity that it used to make part 4A, there would have been an opportunity cost to factor into the analysis. 10-44 Learning Objective 10-4 Prepare an analysis showing whether a special order should be accepted. 10-45 Key Terms and Concepts A special order is a one-time order that is not considered part of the company’s normal ongoing business. When analyzing a special order, only the incremental costs and benefits are relevant. Since the existing fixed manufacturing overhead costs would not be affected by the order, they are not relevant. 10-46 Factors to be considered in the decision to Accept or Reject Special Sales Is unnecessary competition created? ◦ If yes, it is normally rejected. If regular sales are lost due to the acceptance of a special sales order, the lost contribution margin from regular sales becomes as an opportunity cost that should be deducted from the incremental profit of accepting the special order. 10-47 Factors to be considered in the decision to Accept or Reject Special Sales Do we have an idle or no idle capacity? ◦ If there is no alternative use of capacity, the incremental profit (loss) is the difference between incremental sales and incremental cost and expenses. ◦ The incremental profit(loss) from the special sales should be compared would the best benefit that may be derived from the alternative use of the capacity to get the net advantage or 10-48 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? 10-49 Special Orders $8 variable cost 10-50 Special Orders If Jet accepts the special order, the incremental revenue will exceed the incremental costs. In other words, net operating income will increase by $6,000. This suggests that Jet should accept the order. Increase in revenue (3,000 × $10) Increase in costs (3,000 × $8 variable cost) Increase in net income $ 30,000 24,000 $ 6,000 Note: This answer assumes that the fixed costs are unavoidable and that variable marketing costs must be incurred on the special order. 10-51 Special Orders Incremental Revenue (Inflows) Incremental Cost (Outflows) Incremental Income/ Loss Accept if the result is income. Reject if the result is Loss. P XX (XX) XX 10-52 Quick Check Northern Optical ordinarily sells the X-lens for $50. The variable production cost is $10, the fixed production cost is $18 per unit, and the variable selling cost is $1. A customer has requested a special order for 10,000 units of the X-lens to be imprinted with the customer’s logo. This special order would not involve any selling costs, but Northern Optical would have to purchase an imprinting machine for $50,000. (see the next page) 10-53 Quick Check What is the rock bottom minimum price below which Northern Optical should not go in its negotiations with the customer? In other words, below what price would Northern Optical actually be losing money on the sale? There is ample idle capacity to fulfill the order and the imprinting machine has no further use after this order. a. $50 b. $10 c. $15 d. $29 10-54 Quick Check What is the rock bottom minimum price below which Northern Optical should not go in its negotiations with the customer? In other words, below what price would Northern Optical actually be losing money on the sale? There is ample idle capacity to fulfill the order and the imprinting machine has no further use after this order. Variable production cost $100,000 a. $50 Additional fixed cost + 50,000 b. $10 Total relevant cost $150,000 c. $15 Number of units 10,000 d. $29 Average cost per unit = $15 10-55 Learning Objective 10-5 Determine the most profitable use of a constrained resource....
View Full Document

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture