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Relevant Information and Decision Making: Production Decisions

Relevant Information and Decision Making: Production Decisions. Chapter 6. Learning Objective 1. Use opportunity cost to analyze the income effects of a given alternative. Opportunity, Outlay, and Differential Costs. Differential cost (revenue) is the difference in

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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. Learning Objective 1 • Use opportunity cost to • analyze the income • effects of a given • alternative.

  3. 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.

  4. 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.

  5. Learning Objective 2 • Decide whether to make or to • buy certain parts or products.

  6. 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.

  7. 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 labor 20,000 .02 Variable overhead 40,000 .04 Fixed overhead 80,000 .08 Total costs $200,000 $.20 Make-or-Buy Example

  8. 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?

  9. Buy Make Total Per Bottle Total Per Bottle Purchase cost $180,000 $.18 Direct material $ 60,000 $.06 Direct labor 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 favor of making $ 10,000 $.01 Relevant Cost Comparison

  10. 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?

  11. 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)

  12. Learning Objective 3 • Decide whether a joint product • should be processed beyond • the split-off point.

  13. 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.

  14. 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.

  15. 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.

  16. 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

  17. 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 net sales price of YA would be $.16 per liter, a total of $80,000.

  18. Illustration of Sell or Process Further Sell at Split-off as Y Process Further and Sell as YA Difference Revenues $30,000 $80,000 $50,000 Separable costs beyond split-off @ $.08 – 40,000 40,000 Income effects $30,000 $40,000 $10,000

  19. Learning Objective 4 • Identify irrelevant information • in disposal of obsolete • inventory.

  20. 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

  21. 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.

  22. 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?

  23. 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

  24. 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.

  25. 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.

  26. 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

  27. Learning Objective 5 • Decide whether to keep • or replace equipment.

  28. 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 ?

  29. 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.

  30. 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

  31. 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.

  32. 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.

  33. 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.

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

  35. Four 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

  36. Learning Objective 6 • Explain how unit costs • can be misleading.

  37. Beware of Unit Costs There are two major ways to go wrong when using unit costs in decision making: • including irrelevant costs • comparing unit costs not computed • on the same volume basis

  38. Example of Volume Basis Decision Assume that a new $100,000 machine with a five-year life can produce 100,000 units a year at a variable cost of $1 per unit, as opposed to a variable cost per unit of $1.50 with an old machine. Is the new machine a worthwhile acquisition?

  39. Example of Volume Basis Decision Old Machine New Machine Units 100,000 100,000 Variable cost per unit $1.50 $1.00 Variable costs $150,000 $100,000 Straight-line depreciation 0 20,000 Total relevant costs $150,000 $120,000 Unit relevant costs $1.50 $1.20

  40. Example of Volume Basis Decision It appears that the new machine will reduce costs by $.30 per unit. However, if the expected volume is only 30,000 units per year, the unit costs change in favor of the old machine.

  41. Example of Volume Basis Decision Old Machine New Machine Units 30,000 30,000 Variable cost per unit $1.50 $1.00 Variable costs $45,000 $30,000 Straight-line depreciation 0 20,000 Total relevant costs $45,000 $50,000 Unit relevant costs $1.50 $1.6667

  42. Learning Objective 7 • Discuss how performance • measures can affect • decision making.

  43. Decision Making and Performance Evaluation To motivate managers to make the right choice, the method used to evaluate performance should be consistent with the decision model.

  44. Decision Making and Performance Evaluation Consider the replacement decision, discussed earlier, where replacing the machine had a $2,500 advantage over keeping it. Because performance is often measured by accounting income, consider the accounting income in the first year after replacement compared with that in years 2, 3, and 4.

  45. Decision Making and Performance Evaluation Year 1 Years 2, 3, and 4 Keep Replace Keep Replace Cash operating costs $5,000 $3,000 $5,000 $3,000 Depreciation 1,000 2,000 1,000 2,000 Loss on disposal ($4,000 – $2,500) 0$1,500 0 0 Total charges against revenue $6,000 $6,500 $6,000 $5,000

  46. Decision Making and Performance Evaluation If the machine is kept rather than replaced, first-year costs will be $500 lower ($6,500 – $6,000), and first-year income will be $500 higher.

  47. Learning Objective 8 • Construct absorption and • contribution format income • statements and identify which • is better for decision making.

  48. Absorption Approach The absorption approach is a costing approach that considers all factory overhead (both variable and fixed) to be product (inventoriable) costs. Factory overhead becomes an expense in the form of manufacturing cost of goods sold only as sales occur.

  49. Contribution Approach In contrast, the contributionapproach is used by many companies for internal (management accounting) reporting. It emphasizes the distinction between variable and fixed costs. The contribution approach is not allowed for external financial reporting.

  50. Comparing Contribution and Absorption Approaches Manufacturing costs Nonmanufacturing costs Variable costs A. Variable manufacturing costs B. Variable nonmanufacturing costs Fixed costs C. Fixed manufacturing costs D. Fixed nonmanufacturing costs

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