Decisions Making

Part 2 – Week 13

Management Accounting
 Retain or Replace Equipment: Example

• Assessment of replacement of a factory machine

Old Machine New

Machine
Book value $40,000
Cost $120,000
Remaining useful life four years
Scrap value -0- -0-

Variable costs:
Decrease from $160,000 to $125,000 annually
 INCREMENTAL ANALYSIS
Retain or Replace Equipment
Example (Continued)
Net Income
Retain Replace Increase (Decrease)
Variable manufacturing costs $640,000 $500,000b $140,000
New machine cost 120,000 (120,000)
Total $640,000 $620,000 $ 20,000

a
(4 years x $160,000) b
(4 years x $125,000)

Decision:
Decision: replace
replaceequipment.
equipment.
Lower
Lowervariable
variablemanufacturing
manufacturingcosts
costsmore
morethan
thanoffset
offsetcost
costofofnew
new
equipment.
equipment.
The
Thebook
bookvalue
valueofofthe
theold
oldmachine
machinedoes
doesnot
notaffect
affectthe
thedecision.
decision.
 Sell or Process Further

• Manufacturers may have to decide, at a given point in production,

whether to sell now or to process further and sell at a higher price
later.

• Decision Rule:

Process further as long as the incremental revenue from such

processing exceeds the incremental processing costs
 Sell or Process Further
Cost to manufacture one unfinished table:
Direct materials $15
Direct labor 10
Variable manufacturing overhead 6
Fixed manufacturing overhead 4
Manufacturing cost per unit $35
Selling price of unfinished unit is $50
Unused capacity used to finish the tables to sell for $60 per table.
Relevant unit costs of finishing tables:
 Direct materials increase $2
 Direct labor increase $4
 Variable manufacturing overhead costs increase by $2.40 (60 percent of
direct labor increase)
 Fixed manufacturing costs will not increase
 Sell or Process Further
• Decision is : Process Further; Incremental revenue $ 10,
Incremental processing cost $ 8.40; Income increases by $1.6 per
unit

Process Net Income

Sell Further Increase (Decrease)
Sales per unit $50.00 $60.00 $10.00
Cost per unit
Direct materials 15.00 17.00 (2.00)
Direct labor 10.00 14.00 (4.00)
Variable manufacturing overhead 6.00 8.40 (2.40)
Fixed manufacturing overhead 4.00 4.00 - 0 -
Total $35.00 $43.40 $(8.40)

Net income per unit $15.00 $16.60 $1.60

 INCREMENTAL ANALYSIS
Sell or Process Further
Multiple-Product Case
 Especially appropriate when multiple products are produced simultaneously
 Many end-products are produced from a single raw material and a common production
process
 Joint products - multiple end products
 Petroleum – gasoline, lubricating oil, kerosene
 Meat Packing – meat, hides, bones
 INCREMENTAL ANALYSIS
Sell or Process Further
Multiple-Product Case

 Joint costs
 all costs incurred prior to split-off point
 allocate to individual products based on relative sales value

 Sunk costs
 already incurred and cannot be changed
 irrelevant for sell or process
further decisions
Joint costs are sunk costs for sell or process further decisions.
 INCREMENTAL ANALYSIS
Sell or Process Further
Multiple-Product Case

Example - Marais Creamery decision:

Sell cream and skim milk
or
Process them further before selling
 INCREMENTAL ANALYSIS
Sell or Process Further
Multiple-Product Case – Example (Continued)

 Sell cream or process further into cottage cheese?

 Joint cost allocated to cream $ 9,000
 Processing cream into cottage cheese $10,000
 Expected revenue per day:
Cream $19,000 Cottage cheese $27,000

Process Net Income

Sell Further Increase (Decrease)
Sales per day $19,000 $27,000 $ 8,000
Cost per day
Processing cream into
cottage cheese -0- 10,000 (10,000)
$19,000 $17,000 $ (2,000)

Decision: Do not process the cream further.

Incremental revenue ($8,000) is less than incremental costs ($10,000); income decreases $2,000.
 INCREMENTAL ANALYSIS
Sell or Process Further
Multiple-Product Case – Example (Continued)

 Sell skim milk or process further into condensed milk?

 Joint cost allocated to skim milk $ 5,000
 Processing skim milk into condensed milk $ 8,000
 Expected revenue per day:
Skim milk $11,000 Condensed milk $26,000

Process Net Income

Sell Further Increase (Decrease)
Sales per day $11,000 $26,000 $ 15,000
Cost per day
Processing skim milk into
condensed milk -0- 8,000 ( 8,000)
$11,000 $18,000 $ 7,000

Decision: Process the skim milk further.

Incremental revenue ($15,000) exceeds incremental costs ($8,000);
income increases $7,000.