Chapter 12 - Relevant Costs - 12-1 MGT223 Relevant Costs...

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Unformatted text preview: 12-1 MGT223 Relevant Costs for Decision Making Chapter Twelve Cost Concepts for Decision Making A relevant cost is a cost that Identifying Relevant Costs An avoidable cost 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: costs. costs. costs that do not differ between the costs do alternatives. 12-2 Relevant Cost Analysis: A Two-Step Process Step 1 Eliminate costs and benefits that do not differ between alternatives. Step 2 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 Cynthia, an Ottawa student, is considering visiting her friend in in Waterloo. She can drive or take the train. By car, it is 230 miles to her or take the train. By car, it is 230 miles miles friend’s apartment. She is trying to decide which alternative is less expensive and has gathered the following information: Automobile Costs (based on 10,000 miles driven per year) Annual Cost of Fixed Items Annual straight-line depreciation on car $ 2,800 Cost of gasoline Annual cost of auto insurance and license 1,380 Maintenance and repairs Parking fees at school 360 Total average cost 1 2 3 4 5 6 $45 per month × 8 months $45 per month × 8 months Cost per Mile 0.280 0.050 0.138 0.065 0.036 $ 0.569 $ $1.60 per gallon ÷ 32 MPG $1.60 per gallon ÷ 32 MPG $18,000 cost – $4,000 salvage value ÷ 5 years $18,000 cost – $4,000 salvage value ÷ 5 years Identifying Relevant Costs Automobile Costs (based on 10,000 miles driven per year) 1 2 3 4 5 6 Annual Cost of Fixed Items Annual straight-line depreciation on car $ 2,800 Cost of gasoline Annual cost of auto insurance and license 1,380 Maintenance and repairs Parking fees at school 360 Total average cost 7 8 9 10 11 12 13 Cost per Mile 0.280 0.050 0.138 0.065 0.036 $ 0.569 $ Some A dditional Information R eduction in res ale value of car per mile of wear R ound-tip train fare B enefits of relaxing on train trip C t of putting dog in kennel while gone os B enefit of having car in Waterloo H s of parking car in Waterloo as le Per day cos of parking car in Waterloo t $ 0.026 $ 104 ???? $ 40 ???? ???? $ 25 12-3 Identifying Relevant Costs Which costs and benefits are relevant in Cynthia’s decision? The cost of the car is a cost and is not relevant to the current decision. The annual cost of insurance is . It will remain the same if she drives or takes the train. However, the cost of gasoline is clearly if she decides to drive. If she takes the train, the cost would now be incurred, so it varies depending on the decision. Identifying Relevant Costs Which costs and benefits are relevant in Cynthia’s decision? The cost of The The is not relevant is relevant. In the longbecause it must run these costs be paid if Cynthia depend upon miles drives or takes driven. the train. At this point, we can see that some of the average cost of $0.569 per mile are relevant and others are not. Identifying Relevant Costs Which costs and benefits are relevant in Cynthia’s decision? The decline in resale The value due to additional miles is a relevant cost. The The is clearly relevant. If she drives the cost can be avoided. The iis relevant even s though it is difficult to assign a dollar value to the benefit. is not relevant because Cynthia will incur the cost if she drives or takes the train. 12-4 Identifying Relevant Costs Which costs and benefits are relevant in Cynthia’s decision? The cost of is The relevant because it can be avoided if she takes the train. The benefits of having a car in Waterloo and the problems of finding a parking space are both relevant but are difficult to assign a dollar amount. 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. Relevant Financial Cost of Driving Gasoline (460 @ $0.050 per mile) Maintenance (460 @ $0.065 per mile) Reduction in resale (460 @ $0.026 per mile) Parking in New York (2 days @ $25 per day) Total $ 23.00 29.90 11.96 50.00 $ 114.86 Relevant Financial Cost of Taking the Train Round-trip ticket $ 104.00 Adding/Dropping Segments One of the most important decisions managers make is whether to add or drop a business segment, such as a product or a store. Let’s see how relevant costs should be used in this type of decision. 12-5 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 dropping this product line. A Contribution Margin Approach DECISION RULE Lovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings the lost contribution margin. Let’s look at this solution. 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 Ne t opera ting l oss $ 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) 12-6 Adding/Dropping Segments Segment Income Statement Digital Watches Sales $ 500,000 Less: variable expenses Investigation has revealed that total fixed general Investigation has revealed that total fixed general Variable manufacuring costs $ 120,000 factory overhead and general factory overhead and general Variable shipping costs 5,000 administrative expenses would75,000 affected if Commissions 200,000 administrative expenses would not be affected if not be Contribution margin the digital watch line is dropped. The fixed the digital watch line is dropped. The $ 300,000 fixed Less: fixed expenses general factory overhead and general general factory overhead 60,000general and General factory overhead $ administrative expenses assigned to this product administrative expenses assigned to this product Salary of line manager 90,000 Depreciation of equipment to other product lines. 50,000 would be reallocated to other product lines. would be reallocated Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 400,000 Ne t opera ti ng l oss $ (100,000) Adding/Dropping Segments Segment Income Statement Digital Watches Sales $ 500,000 Less: variable expenses Variable manufacturing to manufacture The equipment usedcosts $ 120,000 The equipment used to manufacture Variable shipping costs 5,000 digital watches has no resale digital watches has no resale Commissions 75,000 200,000 value or alternative use. value or alternative use. Contribution margin $ 300,000 Less: fixed expenses General factory overhead $ 60,000 Salary of line manager 90,000 Depreciation of equipment 50,000 Should Lovell retain or drop Should Lovell retain or drop Advertising - direct 100,000 the digital watch segment? Rent - factory space the digital watch segment? 70,000 General admin. expenses 30,000 400,000 Ne t opera ti ng l oss $ (100,000) 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 $ (300,000) $ 260,000 (40,000) 12-7 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. Comparative Income Approach Solution Drop Keep Digital Digital Watches Difference Watches Sales $ 500,000 $ $ (500,000) Less variable expenses: Manufacturing expenses 120,000 120,000 Shipping 5,000 5,000 Commissions 75,000 75,000 Total variable expenses 200,000 200,000 Contribution margin 300,000 (300,000) Less fixed expenses: General factory overhead 60,000 Salary of line manager 90,000 Depreciation 50,000 If the digital watch If the digital watch Advertising - direct 100,000 line is dropped, the line is dropped, the Rent - factory space 70,000 company gives up General admin. expenses 30,000 company gives up Total fixed expenses 400,000 its contribution its contribution Net operating loss $ (100,000) margin. margin. Comparative Income Approach Solution Drop Keep Digital Digital Watches Difference Watches Sales $ 500,000 $ $ (500,000) Less variable expenses: Manufacturing expenses 120,000 120,000 Shipping 5,000 5,000 Commissions 75,000 75,000 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 Depreciation 50,000 On 100,000 On the other hand, the general the other hand, the general Advertising - direct Rent - factory space 70,000 factory overhead would be the factory overhead would be the General admin. expenses 30,000 same. So this cost really isn’t same. So this cost really isn’t Total fixed expenses 400,000 Net operating loss $ (100,000) 12-8 Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Sales $ 500,000 $ Less variable expenses: But we wouldn’t need -a But we 120,000 wouldn’t need a Manufacturing expenses manager for5,000 product -line Shipping manager for the product line the Commissions 75,000 anymore. anymore. Total variable expenses 200,000 Contribution margin 300,000 Less fixed expenses: General factory overhead 60,000 60,000 Salary of line manager 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) Difference $ (500,000) 120,000 5,000 75,000 200,000 (300,000) 90,000 Comparative Income Approach Solution Drop Keep Digital Digital Watches Difference Watches Sales $ 500,000 $ $ (500,000) IIf the digital watch line is dropped, the net -book value Less variable expenses: f the digital watch line is dropped, the net book value Manufacturing expenses 120,000 120,000 of the equipment would be written off. The depreciation of the equipment would be written off. The depreciation Shipping 5,000 5,000 that would have been taken will flow through the75,000 that would have been taken will flow through the Commissions 75,000 Total variable expenses statement as a loss instead. 200,000 200,000 income statement as a loss instead. income 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) Comparative Income Approach Solution Drop Keep Digital Digital Watches Watches Sales $ 500,000 $ Less variable expenses: Manufacturing expenses 120,000 Shipping 5,000 Commissions 75,000 Total variable expenses 200,000 Contribution margin 300,000 Less fixed expenses: General factory overhead 60,000 60,000 Salary of line manager 90,000 Depreciation 50,000 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 30,000 Total fixed expenses 400,000 140,000 Net operating loss $ (100,000) $ (140,000) Difference $ (500,000) 120,000 5,000 75,000 200,000 (300,000) 90,000 100,000 70,000 260,000 $ (40,000) 12-9 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. 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 Direct labour Variable overhead Depreciation of special equip. Supervisor's salary General factory overhead Unit product cost $ 9 5 1 3 2 10 $ 30 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 labour 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 we accept the supplier’s offer? 12-10 The Make or Buy Decision Cost Per Unit Outside purchase price $ 25 Direct materials Direct labour Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost $ 9 5 1 3 2 10 $ 30 Cost of 20,000 Units Buy Make $ 500,000 180,000 100,000 20,000 40,000 $ 340,000 $ 500,000 20,000 × $9 per unit = $180,000 The Make or Buy Decision Cost Per Unit Outside purchase price $ 25 Direct materials Direct labour Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost $ 9 5 1 3 2 10 $ 30 Cost of 20,000 Units Buy Make $ 500,000 180,000 100,000 20,000 40,000 $ 340,000 $ 500,000 The special equipment has no resale The special equipment has no resale value and is a sunk cost. value and is a sunk cost. The Make or Buy Decision Cost Per Unit Outside purchase price $ 25 Direct materials Direct labour Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost $ 9 5 1 3 2 10 $ 30 Cost of 20,000 Units Buy Make $ 500,000 180,000 100,000 20,000 40,000 $ 340,000 $ 500,000 Not avoidable; irrelevant. If the product is Not avoidable; irrelevant. If the product is dropped, it will be reallocated to other products. dropped, it will be reallocated to other products. 12-11 The Make or Buy Decision Cost Per Unit Outside purchase price $ 25 Direct materials Direct labour Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost $ 9 5 1 3 2 10 $ 30 Cost of 20,000 Units Buy Make $ 500,000 180,000 100,000 20,000 40,000 $ 340,000 $ 500,000 Should we make or buy part 4A? Opportunity Cost An opportunity cost is the Opportunity costs are not actual dollar outlays and are not recorded in the formal accounts of an organization. How would this concept potentially relate to the Essex Company? 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 12-12 Special Orders Jet, Inc. makes a single product whose normal selling price Jet, is $20 per unit. A foreign distributor offers to purchase 3,000 units for $10 foreign per unit. This is a one-time order that would not affect the This oneone-time company’s regular business. Annual capacity is 10,000 units, but Jet, Inc. is currently Annual producing and selling only 5,000 units. Should Jet accept the offer? Special Orders Jet, Inc. Contribution Income Statement Revenue (5,000 × $20) $ 100,000 Variable costs: Direct materials $ 20,000 Direct labour 5,000 $8 Manufacturing overhead 10,000 $8 variable cost Marketing costs 5,000 Total variable costs 40,000 Contribution margin 60,000 Fixed costs: Manufacturing overhead $ 28,000 Marketing costs 20,000 Total fixed costs 48,000 Net operating income $ 12,000 Special Orders If Jet accepts the offer, operating income will increase by $6,000. I ncrease in revenue (3,000 × $10) Increase Increase in costs (3,000 × $8 variable cost) Increase in net income $ 30,000 24,000 $ 6,000 Note: This answer assumes that fixed costs are Note: unaffected by the order and that variable marketing costs must be incurred on the special order. 12-13 Joint Costs • In some industries, a number of end products are produced from a single raw material input. • Two or more products produced from a common input are called joint products. products • The point in the manufacturing process where each joint product can be recognized as a separate product is called the split-off point. split- point split-off ...
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This note was uploaded on 10/10/2011 for the course ECON 110 taught by Professor Boliy during the Spring '11 term at Aachen University of Applied Sciences.

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