Dr. Charleston Tom, Assoc.

Professor of Accounting

Relevant Cost Information and Short Term Production Decision Chapter 13

Information and the Decision Process

A decision model is a formal method for making a choice, often involving quantitative and qualitative analysis.

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Five-Step Decision Process

Step 1 1. Gather Information Historical Costs Other Information Specific Predictions

Step 2. F Feedback

Make Predictions

Step 3.

Choose an Alternative

Step 4. Implement the Decision

Step 5. Evaluate Performance

Identifying Relevant Cost Information

Relevant Costs are those affect future outcome and make difference among alternatives:
Opportunity Cost Avoidable Cost Differential Cost additional cost incurred when choosing an alternative

Unavoidable costs are never relevant and include:

Sunk costs. Future costs that do not differ between the alternatives.
Common Cost Joint Cost

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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 companys annual sales and costs with and without the new machine are:
Current Situation $ 200,000 70,000 40,000 10,000 120,000 80,000 62,000 62,000 18,000 Situation With New Machine $ 200,000 70,000 25,000 10,000 105,000 95,000 62,000 3,000 65,000 30,000 Differential Costs and Benefits 15,000 15,000 (3,000) (3,000) 12,000

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

Total and Differential Cost Approaches

As you see, the only costs that differ between the alternatives are the direct labor costs savings and the increase in fixed rental costs.
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 70,000 40,000 10,000 120,000 80,000 Situation With New Machine $ 200,000 70,000 25,000 10,000 105,000 95,000 62,000 3,000 65,000 65 000 30,000 Differential Costs and Benefits 15,000 15,000 (3,000) (3,000) (3 000) 12,000

We can efficiently analyze the decision by 62,000 looking at the different costs and revenues and000 g 62,000 62 $ 18,000 arrive at the same solution.
Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) Increase in fixed rental expenses Net annual cost saving from renting the new machine $ $ 15,000 (3,000) 12,000

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Using Relevant Cost Information in Decision Making

Cases that highlight what is relevant costs:
Accept / Reject a Special Order Make / Buy An Input p p g Keep / Drop a Business Segment Sell Now / Process Further Optimize Product Mix on Scarce Resource

One-Time-Only Special Order Example

Revenue ($20) - CGS ($15) GM - S&A Exp. (Fixed) Operating Income Unit CGS $15: UVC UFMO UC 1Mil. 1Mil Units $20,000 15,000 5,000 4,000 1,000 $12 $ 3 $15

Should we accept a sales order of 100,000 units at offered price of $13?

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One-Time-Only Special Order Example

Existing 1Mil. Units Revenue ($20) $20,000 - CGS ($15) 15,000 GM 5,000 - S&A Exp. (Fixed) 4,000 Operating Income p g 1,000 Conclusion: Reject! Special Order 100K Units $1,300 1,500 -200 0 -200 Total 1.1 Mil. $21,300 16,500 4,800 4,000 800

One-Time-Only Special Order Example

Should we accept a sales order of 100 000 units at offered price of $13? 100,000

Correct analysis:
Existing Revenue - Variable Cost CM - FMO - S&A Expense (all fixed) Operating Income 20,000 12,000 8,000 3,000 3 000 4,000 1,000 Special Order 1,300 1,200 100 0 0 100 Total $21,300 13,200 8,100 3,000 3 000 4,000 1,100

Change in Profit = (Price UVC) x Units TFC = (13 12 ) x 100,000 0 = $100,000 Decision: Accept!

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Outsourcing versus Insourcing

Outsourcing is purchasing goods and services from outside vendors. Insourcing is producing goods or providing services within the organization.

Make-or-Buy Decision
Make Direct Variable Costs $140,000 FMO - Traceable portion 20,000 - Unavoidable portion 60,000 Total Cost 220,000 Buy $200,000

$200,000

Should the Co. Outsourcing? How about if the Co. could lease vacant facility for $50000?

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Make-or-Buy Decision
Make Buy y Differential Cost Direct Variable Costs $140,000 $200,000 (60000) FMO - Traceable portion 20,000 0 20000 - Unavoidable portion 60,000 60,000 0 Total Cost $220,000 $260,000 (40000) Net Amount to be Paid if Buy $200,000 - Avoidable Costs if Buy = VC + Traceable FC = $160,000 Cost Differences $40,000 Conclusion Make!

Make-or-Buy Decision
What Happens if the company can rent the vacant space for $50,000? pp p y p , Net Amount to be Paid if Buy (200k-50k=) $150,000 - Avoidable Cost for Buy = VC + Traceable FC = $160,000 Cost Differences -$10,000 Conclusion Buy!

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Keep-or-drop Decision
Brick Revenue $1,000 $1 000 - Store direct costs (VC + Traceable FC) 500 Product Margin 500 Amortized Common Cost (% rev) 600 Operating Income (100) Should we drop the loser? Mortar $4,000 $4 000 1,000 3,000 2,400 600 Company $5,000 $5 000 $1,500 3,500 3,000 500

Revenue - Store direct costs (VC + Traceable FC) Product Margin Amortized Common Cost Operating Income

0 0 0 0

$4,000 1,000 3,000 3,000 0

$4,000 $1,500 $3,000 3,000 0

Traceable or Common?
Fix Cost: Salary for brick product line manager General factory overhead Depreciation on factory building Property tax on factory Insurance on brick inventory Advertising on brick products

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Sell now or Process Further?

In some industries, a number of end products are industries 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

Joint Products
Joint Costs
Common Production Process $200

Cream C
25 gl. @ $8

Separate Processing $280 Separate Separate Processing Processing $520

Butter 20gl. @$25

Joint Input $200

Skim Milk
75 gl. @ $2

Cond. Milk 50gl. @$22

Milky Liquid 15gl. @$.1

Byproduct

SplitSplit-Off Point

Separate Product Costs

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Sell now or Process Further?

Sell Cream or Butter?
Incremental Revenue: 20g.x$25-25gx$8=$500-$200=$300 Incremental Cost: ($280) Extra Income if Process Further $20

Joint costs are common costs incurred to simultaneously produce a variety of end products, irrelevant in this decision

Optimize Product Mix on Constrained Resource

Ensign Company produces two products shown below:
Product 1 Selling price per unit Less variable expenses per unit Contribution margin per unit Current demand per week (units) Contribution margin ratio Processing time required on machine A1 per unit Total Time Required 60 36 $ 24 2,000 40% 1.00 min. 2,000 min. $ $ 2 50 35 $ 15 2,200 30% 0.50 min. 1,100 min.

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Utilization of a Constrained Resource

Machine A1 is the constrained resource and is being used at 100% of its capacity. There is excess capacity on all other machines. Machine A1 has a capacity of 2,400 minutes per week.

Should Ensign focus its efforts on Product 1 or 2?

Quick Check
How many units of each product can be processed through Machine A1 in one minute? Product 1 1 unit 1 u t unit 2 units 2 units Product 2 0.5 unit 2.0 u ts .0 units 1.0 unit 0.5 unit

a. b. c. d.

I was just checking to make sure you are with us.

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Quick Check
What generates more profit for the company, using one minute of machine A1 to process Product 1 or i t f hi t P d t using one minute of machine A1 to process Product 2? a. Product 1 b. Product 2 c. They both would generate the same profit d. Cannot be determined

With one minute of machine A1, we could make 1 unit of What generates more profit formargin of $24,using Product 1, with a contribution the company, or 2 units of Product 2 each with a contribution d t 1 or one minute of 2, hi A1 to process Product of i t f machine t P margin $15. 2 one minute of machine A1 to process Product using $15 > $24 2? a. Product 1 b. Product 2 c. They both would generate the same profit d. Cannot be determined

Quick Check

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Utilization of a Constrained Resource

The key is the contribution margin per unit of the constrained resource.
Product 1 Contribution margin per unit Time required to produce one unit Contribution margin per minute C t ib ti i i t $ 2 24 $ 15 1.00 min. 0.50 min. $ 24 min. i $ 30 min. i

Product 2 should be emphasized. Provides more valuable use of the constrained resource machine A1, yielding a contribution margin of $30 per minute as opposed to $24 for Product 1.

Utilization of a Constrained Resource

Alloting Our Constrained Recource (Machine A1) Weekly demand for Product 2 Time required per unit Total time required to make Product 2 Total time available Time used to make Product 2 Time available for Product 1 Time required per unit Production of Product 1 2,200 units 0.50 min. 1,100 min. 2,400 2 400 1,100 1,300 1.00 1,300 min. min min. min. min. units

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Utilization of a Constrained Resource

According to the plan, we will produce 2,200 units of Product 2 and 1,300 of Product 1. Our contribution margin looks like this.
Production and sales (units) Contribution margin per unit C t ib ti i it Total contribution margin Product 1 1,300 $ 24 $ 31,200 Product 2 2,200 $ 15 $ 33,000

The total contribution margin for Ensign is $64,200.

Quick Check
Colonial Heritage makes reproduction colonial furniture from select hardwoods. hardwoods
Selling price per unit Variable cost per unit Board feet per unit M onthly dem and C hairs $80 $30 2 600 Tables $400 $200 10 100

The company s supplier of hardwood will only be companys able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand? a. Yes 2 600 + 10 100 = 2,200 > 2,000 b. No

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Quick Check
S elling price per unit V ariable cost per unit i bl t it B oard feet per unit M onthly dem and C hairs $80 $30 2 600 Tables $400 $200 10 100

The companys supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would p maximize profits? a. 500 chairs and 100 tables b. 600 chairs and 80 tables c. 500 chairs and 80 tables d. 600 chairs and 100 tables

Chairs Tables Selling price $ 80 $ 400 Variable cost 30 200 Contribution margin $ 50 $ 200 C hairs Tables S elling price per unit $400 2 Board feet $80 10 V ariable cost per unit i bl t it $30 $200 CM per board foot $ 25 $ 20

Quick Check
2 600

B oard feet per unit M onthly dem and

10 100

Production of chairs

600

The companys supplier of hardwood will 1,200 able to only be Board feet required supply 2,000 boardBoard feet remaining plan would feet this month. What 800 10 p maximize profits? Board feet per table Production 80 a. 500 chairs and 100 tables of tables b. 600 chairs and 80 tables c. 500 chairs and 80 tables d. 600 chairs and 100 tables

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Quick Check
As before, Colonial Heritages supplier of hardwood will only be able to supply 2,000 board feet this month. ill l b bl t l 2 000 b d f t thi th Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood? a. $40 per board foot b. $25 per board foot c. $20 per board foot d. Zero

Quick Check
As before, Colonial Heritages supplier of hardwood will only be able to supply 2,000 board feet this month. ill l b bl t l 2 000 b d f t thi th Assume the company follows the plan make tables. In The additional wood would be used towe have proposed. Up to how much should of additional wood willing to this use, each board foot Colonial Heritage be will allow pay above the earn an additional more hardwood? the company tousual price to obtain $20 of contribution a. $40 per board margin and profit. foot b. $25 per board foot c. $20 per board foot d. Zero

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Optimal Product-Mix Decisions under Capacity Constraints Linear Programming

Storage constraints limit 110 boat engine per day

Optimum Product-Mix Decisions under Capacity Constraints Linear Programming

Objective Function Max -> TCM = $ $240 S + $ $375 B Subject to: Storage constraint: B 110 unit Assembly Dept C t i t 2S + 5B 600 H A bl D t Constraint: Testing Dept Constraint: 1S + 0.5B 120 H None negative output: S 0; B 0

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Solve Linear Model Graphic Method

250

Boat Engine (u units) Boat Engine (u units)

200 150

B=110
100 50
0 50 100 150 200 250 300 350

Snowmobile Engine (units)

Solve Linear Model Graphic Method

250 200 150 100

Feasible Product Mix Region

90
50
0 50 75 100 150 200 250 300 350

Snowmobile Engine (units)

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Solve Linear Model Graphic Method

250

Boat Engine (u units)

200 150 100

Max TCM = $240 S + $375 B = 240 x 75 + 375 x 90=$51,750

90
50
0 50 75 100 150 200 250 300 350

Snowmobile Engine (units)

Equipment-Replacement Decisions Example

Existing Replacement E i i R l Machine Machine Original cost $80,000 $105,000 Useful life 4 years 4 years p Accumulated depreciation $50,000 Book value $30,000 Disposal price $14,000 Annual costs $46,000 $ 10,000

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