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Relevant Information and Decision Making: Production Decisions

Relevant Information and Decision Making: Production Decisions. Chapter 6. Opportunity, Outlay, and Differential Costs. Differential cost (revenue) is the difference in total cost (revenue) between two alternatives. Incremental cost includes all of the costs of the

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Relevant Information and Decision Making: Production Decisions

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  1. Relevant Informationand Decision Making:Production Decisions Chapter 6

  2. Opportunity, Outlay, and Differential Costs Differentialcost(revenue) is the difference in total cost (revenue) between two alternatives. Incremental costincludes all of the costs of the other alternative plus some additional costs.

  3. Opportunity, Outlay, and Differential Costs An opportunitycost is the maximum available contribution to profit forgone (or passed up) by using limited resources for a particular purpose. An outlaycost requires a cash disbursement.

  4. Make-or-Buy Decisions Managers often must decide whether to produce a product or service within the firm or purchase it from an outside supplier.

  5. Nantucket Nectars Company Cost of Making 12-ounce Bottles Total Cost for 1,000,000 bottles Cost per bottle Direct material $ 60,000 $.06 Direct labour 20,000 .02 Variable overhead 40,000 .04 Fixed overhead 80,000 .08 Total costs $200,000 $.20 Make-or-Buy Example

  6. Make-or-Buy Example Another manufacturer offers to sell Nantucket the same part for $.18. If the company buys the part, $50,000 of fixed overhead would be eliminated. Should Nantucket make or buy the part?

  7. Buy Make Total Per Bottle Total Per Bottle Purchase cost $180,000 $.18 Direct material $ 60,000 $.06 Direct labour 20,000 .02 Variable overhead 40,000 .04 Fixed OH avoided by not making 50,000 .05 0 0 Total relevant costs $170,000 $.17 $180,000 $.18 Difference in favour of making $ 10,000 $.01 Relevant Cost Comparison

  8. Make or Buy andthe Use of Facilities Suppose Nantucket can use the released facilities in other manufacturing activities to produce a contribution to profits of $55,000, or can rent them out for $35,000. What are the alternatives?

  9. Make or Buy andthe Use of Facilities (‘000) Make Buy and leave facilities idle Buy and rent out facilities Buy and use facilities for other products Rent revenue $ — $ — $ 25 $ — Contribution from other products — — — 55 Variable cost of bottles (170) (180) (180) (180) Net relevant costs $(170) $(180) $(155) $(125)

  10. Joint Product Costs Joint products have relatively significant sales values. They are not separately identifiable as individual products until their split-off point. The split-off point is that juncture of manufacturing where the joint products become individually identifiable.

  11. Joint Products Split-off point Product A Separable costs Joint costs Separable costs Product B

  12. Joint Product Costs Separable costs are any costs beyond the split-off point. Joint costs are the costs of manufacturing joint products before the split-off point.

  13. Joint Product Costs Suppose Dow Chemical Company produces two chemical products, X and Y, as a result of a particular joint process. The joint processing cost is $100,000. Both products are sold to the petroleum industry to be used as ingredients of gasoline.

  14. Joint-processing cost is $100,000 Split-off point Joint Product Costs 1 million liters of X at a selling price of $.09 = $90,000 500,000 liters of Y at a selling price of $.06 = $30,000 Total sales value at split-off is $120,000

  15. Joint Products

  16. Illustration of Sell or Process Further Suppose the 500,000 liters of Y can be processed further and sold to the plastics industry as product YA. The additional processing cost would be $.08 per liter for manufacturing and distribution, a total of $40,000. The sales price of YA would be $.16 per liter, a total of $80,000.

  17. Illustration of Sell or Process Further Sell at Split-off as Y Process Further and Sell as YA Difference Revenue - Y $30,000 $80,000 $50,000 Separable costs beyond split-off @ $.08 – (40,000) 40,000 Revenue – X 90,000 90,000 - Joint processing (100,000) (100,000) - Income effects 20,000 $30,000 $10,000

  18. Irrelevance of Past Costs The ability to recognize and thereby ignore irrelevant costs is important to decision makers. Cost of obsolete inventory Book value of old equipment

  19. Example of Irrelevance ofObsolete Inventory Suppose General Dynamics has 100 obsolete aircraft parts in its inventory. The original manufacturing cost of these parts was $100,000.

  20. Example of Irrelevance ofObsolete Inventory General Dynamics can... remachine the parts for $30,000 and then sell them for $50,000, or scrap them for $5,000. Which should it do?

  21. Expected future revenue $ 50,000 $ 5,000 $45,000 Expected future costs 30,000 0 30,000 Relevant excess of revenue over costs $ 20,000 $ 5,000 $15,000 Accumulated historical inventory cost* 100,000 100,000 0 Net loss on project $(80,000) $ (95,000) $15,000 * Irrelevant because it is unaffected by the decision. Example of Irrelevance ofObsolete Inventory Remachine Scrap Difference

  22. Book Value of Old Equipment The book value of equipment is not a relevant consideration in deciding whether to replace the equipment. Why? Because it is a past, not a future cost.

  23. Book Value of Old Equipment Depreciation is the periodic allocation of the cost of equipment. The equipment’s book value (or net bookvalue) is the original cost less accumulated depreciation.

  24. Book Value of Old Equipment Suppose a $10,000 machine with a 10-year life span has depreciation of $1,000 per year. What is the book value at the end of 6 years? Original cost $10,000 Accumulated depreciation (6 × $1,000) 6,000 Book value $ 4,000

  25. Old Machine Replacement Machine Original cost $10,000 $8,000 Useful life in years 10 4 Current age in years 6 0 Useful life remaining in years 4 4 Accumulated depreciation $ 6,000 0 Book value $ 4,000 N/A Disposal value (in cash) now $ 2,500 N/A Disposal value in 4 years 0 0 Annual cash operating costs $ 5,000 $3,000 Keep or Replace an Old Machine ?

  26. Keep or Replace an Old Machine? What is a sunk cost? A sunk cost is a cost that has already been incurred and, therefore, is irrelevant to the decision-making process.

  27. Relevance of Equipment Data 4 commonly encountered items: • Book value of old equipment • Disposal value of old equipment • Gain or loss on disposal • Cost of new equipment

  28. Book Value of Old Equipment The book value of old equipment is irrelevant because it is a past (historical) cost. Therefore, depreciation on old equipment is irrelevant.

  29. Disposal Value of Old Equipment The disposal value of old equipment is relevant because it is an expected future inflow that usually differs among alternatives.

  30. Gain or Loss on Disposal This is the difference between book value and disposal value. It is therefore a meaningless combination of irrelevant (book value) and relevant items (disposal value). It is best to think of each separately.

  31. Cost of New Equipment The cost of the new equipment is relevant because it is an expected future outflow that will differ among alternatives.

  32. 4 Years Together Keep Replace Difference Cash operating costs $20,000 $12,000 $8,000 Old equipment (book value): Depreciation, or 4,000 – – Lump-sum write-off – 4,000 – Disposal value – (2,500) 2,500 New machine acquisition cost – 8,000 (8,000) Total costs $24,000 $21,500 $2,500 Cost Comparison

  33. Make or Buy: Another Example Sunshine Fruit Company sells premium-quality oranges by mail order. Protecting the fruit during shipping is important, so the company has designed & produces shipping boxes. The annual cost to make 80,000 boxes is: Cost per box = RM2.70.

  34. Make or Buy: Another Example Suppose an external supplier submits a bid to supply Sunshine with boxes for RM2.40 per box. Sunshine must give the supplier the box design specifications, and the boxes will be made according to those specs. Question How much, if any, would Sunshine save by buying the boxes from the external supplier?

  35. Make or Buy: Another Example The key to this question is what will happen to the fixed overhead costs if production of the boxes is discontinued. Assume that all RM60,000 of fixed costs will continue. Then, Sunshine will lose RM36,000 by purchasing the boxes from the supplier: Payment to supplier 80,000 x $2.40 $192,000 Costs saved, variable costs 156,000 Additional costs $ 36,000

  36. Make or Buy: Another Example Question What subjective factors should affect Sunshine‘s decision whether to make or buy the boxes? Some subjective factors are:  Might the supplier raise prices if Sunshine closed down its box-making facility?  Will sub-contracting the box production affect the quality of the boxes?  Is a timely supply of boxes assured, even if the number needed changes?  Does Sunshine State sacrifice proprietary information when disclosing the box specifications to the supplier?

  37. Make or Buy: Another Question Suppose all the fixed costs represent depreciation on equipment that was purchased for RM600,000 and is just about at the end of its 10-year life. New replacement equipment will cost RM1 million and is also expected to last 10 years. In this case, how much, if any, would Sunshine save by buying the boxes from the supplier?

  38. Make or Buy: Another Example In this case the fixed costs are relevant. However, it is not the depreciation on the old equipment that is relevant. It is the cost of the new equipment. Annual cost savings by not producing the boxes now will be: Variable costs $156,000 Investment avoided (annualized) 100,000 Total saved $256,000 The payment to supplier is $256,000-$192,000 = $64,000 less than the savings, so Sunshine would be $64,000 better off subcontracting the production of the boxes.

  39. Joint Products: Another Example The Mussina Chemical Company produced 3 joint products at a joint cost of RM117,000. These products were processed further & sold as follows:

  40. Joint Products: Another Example The company has had an opportunity to sell at split-off directly to other processors. If that alternative had been selected, sales would have been A: RM54,000, B: RM28,000, C: RM54,000. The company expects to operate at the same level of production and sales in the forthcoming year. Consider all the available information, and assume that all cost incurred after split-off are variable.

  41. Joint Products: Another Example Question Could the company increase operating income by altering its processing decisions? If so, what would be the expected overall operating income? Which products should be processed further and which should be sold at split-off?

  42. Joint Products: Another Example

  43. Joint Products: Another Example Expected overall operating income: A: 54,000 + B: 30,000 + C: 75,000 – Joint costs 117,000 = RM42,000

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