CHAPTER 5

1. CHAPTER 5 Relevant Information for Special Decisions

2. Learning Objective To identify the characteristics of relevant information LO1

3. Relevant Information • Two primary characteristics distinguish relevant from useless information: • Relevant information differs among the alternatives under consideration. • Relevant information is future oriented.

4. Sunk Cost A sunk cost has been incurred in a past transaction and cannot be changed. It is not relevant for making current decisions. Wish I hadn’t bought that stock. Cost me $25,000, and now it’s worth only $15,000. I really need a car but don’t have the cash! Just sell the stock and buy the car!

5. Sunk Cost A sunk cost has been incurred in a past transaction and cannot be changed. It is not relevant for making current decisions. You’ve already taken the loss. The $25,000 is a sunk cost. Like I said, sell the stock and buy the car you need. I don’t want to take the loss!

6. Opportunity Costs An opportunity cost is the sacrifice that is incurred in order to obtain an alternative opportunity. The opportunity cost of owning the stock is $15,000. That is the amount you could receive if you decide to sell. I think I am beginning to see what you mean.

7. Relevance Is an Independent Concept Management at Better Bakery Products is debating whether to add a new product, either cakes or pies, to the company’s product line. Projected costs are shown: Under either alternative, a new production supervisor must be hired at a cost of $25,000 per year. Cakes are distributed under a nationally advertised label. Pies are marketed under the company’s own name and will require new advertising.

8. Relevance Is an Independent Concept Which costs are relevant? Material costs are relevant because they differ. Fifty cents can be avoided by choosing cakes instead of pies. Labor costs and the supervisor’s salary are not relevant because they do not differ. The advertising costs can be avoided if the company elects to make cakes. Whether a cost is fixed or variable has no bearing on its relevance.

9. Relevance is Context-Sensitive A particular cost that is relevant in one context may be irrelevant in another. A department store sells men’s, women’s, and children’s clothing. The store manager’s salary could not be eliminated if the store eliminated the line of children’s clothing. Is the store manager’s salary relevant to the decision to stop selling children’s clothing? No, the store manager’s salary will be the same if children’s clothing is no longer sold.

10. Relevance is Context-Sensitive A particular cost that is relevant in one context may be irrelevant in another. Would the store manager’s salary be a relevant cost, if the company was thinking about closing the store completely? Yes, it is a relevant cost. If the store remains open, the company will incur the manager’s salary. If the store is closed, the cost will be eliminated.

11. Relationship BetweenRelevance and Accuracy Information need not be exact to be relevant. You may be considering the purchase of a laptop computer. You may decide to delay your decision because you think the price will decrease. You are not sure of the amount of the price drop, but you do believe part of the cost can be avoided by waiting.

12. For example, suppose you are deciding which of two laptops to purchase. Computer A costs $300 more than Computer B. Both computers satisfy your technical requirements; however, Computer A has a more attractive appearance. Computer A Computer B Quantitative Versus Qualitative Characteristics Relevant information can have both quantitative and qualitative characteristics. A quantitative focus considers the cost, increase in profits, or other numerical aspects of the decision. A qualitative focus considers non-quantitative aspects such as the impact on people and attractiveness of the products.

13. Differential Revenue and Avoidable Cost Relevant revenues must (1) be future oriented and (2) differ for the alternatives under consideration. Since relevant revenues differ between the alternatives, they are sometimes called differential revenues.

14. Differential Revenue and Avoidable Cost Avoidable costs are the costs managers can eliminate by making specific choices.

15. Learning Objective To distinguish between unit-level, batch-level, product level, and facility-level costs and understand how these costs affect decision making. LO2

16. Avoided by eliminating oneunit of product. Avoided when a batch ofwork is eliminated. Avoided if a product lineis eliminated. Some costs may be avoidedif a business segment is eliminated. Relevant (Avoidable) Costs Unit-levelCosts Batch-levelCosts Product-levelCosts Facility-levelCosts

17. Check Yourself Aqua, Inc., makes statues for use in fountains. On January 1, 2007, the company paid $13,500 for a mold to make a particular type of statue. The mold had an expected life of four years and a salvage value of $1,500. On January 1, 2009, the mold had a market value of $3,000, and a salvage value of $1,200. The expected useful life did not change. What is the relevant cost of using the mold during 2009? ($3,000 – $1,200) ÷ 2 years = $900 Of course, Aqua could avoid the cost by selling the mold for its market value of $3,000.

18. Learning Objective To make appropriatespecial orderdecisions. LO3

19. Relevant Information andSpecial 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.

20. 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

21. If the order is accepted, profitability will increase by $11,800. 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?

22. Special Order Decision Opportunity Costs Premier has excess productive capacity. Suppose Premier has the opportunity to lease its excess capacity (unused building and equipment) for $15,000. Should Premier accept the special offer given this new information? If the order is rejected, profitability will decrease by $3,200.

23. 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?

24. 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?

25. Learning Objective To make appropriateoutsourcing decisions. LO4

26. Outsourcing Decisions Companies can sometimes purchase products needed in the manufacturing process for less than it would cost to make them. Buying goods and services from other companies rather than producing them internally is commonly called outsourcing. That test was so easy. How did you score so low? I outsourced my homework!!

27. Outsourcing Decisions Let’s return to our Premier example. Recall that the unit cost per printer was $329.25. A supplier offers to sell an unlimited number of printers to Premier for $240 each. Should Premier accept this outsourcing offer? Step 1Determine the production costs Premier can avoid if itelects to outsource printer production. Cost per unit = $459,300 ÷ 2,000 = $229.65

28. Outsourcing Decisions Step 2Compare the avoidable production costs with the cost ofbuying the product and select the lower-cost option. Premier should reject the outsourcing offer.

29. Outsourcing Decisions Opportunity Costs If Premier purchases the printers, it could use its manufacturing space for storing finished goods inventory. Premier is currently renting warehouse space at the cost of $40,000. Should Premier continue to manufacture the printers? Cost per unit = $499,300 ÷ 2,000 = $249.65

30. Growth and the Level of Production The decision to outsource would change if expected production increases from 2,000 to 3,000 units. Some avoidable costs are fixed relative to production, so cost per unit decreases as volume increases. If Premier outsources the 3,000 printers it will save $40,000 currently being spent on warehouse space. Management should reject the offer, but if growthis expected in the future it must be factored intomanagement’s decision. Cost per unit = $690,300 ÷ 3,000 = $230.10

31. 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 itsproduction to outside suppliers.

32. Learning Objective To make appropriatesegment eliminationdecisions. LO5

33. Segment Elimination Decisions Businesses are frequently organized into operating units known as segments. Segment reports can be prepared for products, services, departments, branches, centers, offices, or divisions. These reports normally show segment revenues and costs. Let’s look at a segment report for Premier Office Products that has divided its operations into three segments: (1) copiers, (2) computers, and (3) printers.

34. Should management eliminate the copier segment?

35. Segment Elimination Decisions • A three part decision: • Determine the amount of relevant revenue that pertains to eliminating the segment. • Determine the amount of cost that can be avoided if the segment is eliminated. • If the relevant revenue is less than the avoidable cost, eliminate the segment. If not, continue to operate it.

36. Segment Elimination Decisions Step 1:If Premier eliminates the copier segment, it will lose the $550,000 of revenue currently earned. If the segment continues, the revenue will be earned. Since the revenue differs between the alternatives, it is relevant.

37. Segment Elimination Decisions Step 2:If Premier eliminates copiers, it will avoid the following costs:

38. Segment Elimination Decisions Step 3:If Premier eliminates copiers, its profits will decrease: The corporate-level facility-sustaining costs will not be eliminated, but will be allocated to the remaining segments.

39. Assuming we eliminate the copier segment and allocate the corporate-level costs to the remaining two divisions equally, the company’s income statement will look like this.

40. Qualitative Considerations • Employee lives will be disrupted. • Sales of different product lines are frequently interdependent. • What will happen to the space freed by the eliminated segment? • Volume changes can affect elimination decisions.

41. Relationships Between Avoidable Costs and Business Activity • Special order decisions affect unit-level and possibly batch-level costs. • Outsourcing can avoid many product-level as well as unit- and batch-level costs. • Segment elimination can avoid some of the facility-level costs. The more complex the decision level, the more opportunities there are to avoid costs.

42. Learning Objective To make appropriateasset replacementdecisions. LO6

43. Equipment Replacement Decisions The equipment replacement decision should be based on profitability rather than physical deterioration. Consider the following:

44. Equipment Replacement Decisions • The original cost, current book value, accumulated depreciation, and annual depreciation expense are measures of cost of the old machine relating to prior periods. They are irrelevant because they are sunk costs. • The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement decision. • The salvage value of the old machine reduces the opportunity cost. The opportunity cost of using the old machine for five more years is $12,000 ($14,000 – $2,000). • The $45,000 operating expenses of using the old machine can be avoided if it is replaced, It is a relevant cost.

45. Equipment Replacement Decisions • The cost of the new machine can be avoided by keeping the old machine. It is a relevant cost. • The relevant cost of purchasing the new machine is $25,000 ($29,000 – $4,000). • The $22,500 of operating expenses can be avoided by keeping the old machine. The operating expenses are relevant costs. Let’s summarize the relevant costs for the two machines.

46. Equipment Replacement Decisions Our analysis shows that Premier should acquire the new machine. Over a five-year period the company will save a total of $9,500($57,000 – $47,500).

47. End of Chapter 5