Horngrenima14e ch06

©2008 Prentice Hall Business Publishing, ©2008 Prentice Hall Business Publishing, Introduction to Management AccountingIntroduction to Management Accounting 14/e,14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6- - 11

Introduction to Management AccountingIntroduction to Management Accounting


Relevant Information for Relevant Information for Decision Making with a Focus Decision Making with a Focus

on Operational Decisionson Operational Decisions

Chapter 6Chapter 6

Introduction to Management Introduction to Management AccountingAccounting


Opportunity, Outlay, and Opportunity, Outlay, and

Differential CostsDifferential Costs

Incremental cost are additional costs or reducedIncremental cost are additional costs or reducedbenefits generated by the proposed alternative.benefits generated by the proposed alternative.Incremental cost are additional costs or reducedIncremental cost are additional costs or reducedbenefits generated by the proposed alternative.benefits generated by the proposed alternative.

DifferentialDifferential cost cost is the difference in is the difference in total cost between two alternatives.total cost between two alternatives.DifferentialDifferential cost cost is the difference in is the difference in total cost between two alternatives.total cost between two alternatives.

LearningLearningObjective 1Objective 1

DifferentialDifferential revenue is the difference in revenue is the difference in total revenue between two alternatives.total revenue between two alternatives.DifferentialDifferential revenue is the difference in revenue is the difference in total revenue between two alternatives.total revenue between two alternatives.

Incremental benefits are the additional revenues or reducedIncremental benefits are the additional revenues or reducedcosts generated by the proposed alternative.costs generated by the proposed alternative.

Incremental benefits are the additional revenues or reducedIncremental benefits are the additional revenues or reducedcosts generated by the proposed alternative.costs generated by the proposed alternative.


Opportunity, Outlay, and Differential Opportunity, Outlay, and Differential

CostsCosts

An outlayAn outlay cost requires a cash disbursement.cost requires a cash disbursement.An outlayAn outlay cost requires a cash disbursement.cost requires a cash disbursement.

An opportunityAn opportunity cost is the maximum availablecost is the maximum availablecontribution to profit forgone (or passed up) bycontribution to profit forgone (or passed up) byusing limited resources for a particular purpose.using limited resources for a particular purpose.

An opportunityAn opportunity cost is the maximum availablecost is the maximum availablecontribution to profit forgone (or passed up) bycontribution to profit forgone (or passed up) byusing limited resources for a particular purpose.using limited resources for a particular purpose.

An incremental analysis is an analysis of the An incremental analysis is an analysis of the additional costs and benefits of a proposed alternative.additional costs and benefits of a proposed alternative.

An incremental analysis is an analysis of the An incremental analysis is an analysis of the additional costs and benefits of a proposed alternative.additional costs and benefits of a proposed alternative.


Opportunity, Outlay, and Differential Opportunity, Outlay, and Differential

CostsCosts

Nantucket Nectars has three alternatives:Nantucket Nectars has three alternatives:1.1. Increase production of Peach juiceIncrease production of Peach juice2.2. Sell the machineSell the machine3. Produce a new drink Papaya Mango3. Produce a new drink Papaya Mango

Nantucket Nectars has three alternatives:Nantucket Nectars has three alternatives:1.1. Increase production of Peach juiceIncrease production of Peach juice2.2. Sell the machineSell the machine3. Produce a new drink Papaya Mango3. Produce a new drink Papaya Mango

Nantucket Nectars has a machine for Nantucket Nectars has a machine for which it paid $100,000 and it is sitting idle.which it paid $100,000 and it is sitting idle.

Nantucket Nectars has a machine for Nantucket Nectars has a machine for which it paid $100,000 and it is sitting idle.which it paid $100,000 and it is sitting idle.


Opportunity CostOpportunity Cost

RevenueRevenue $500,000 $500,000Costs:Costs: Outlay CostsOutlay Costs 400,000400,000 Financial benefit before opportunity costs Financial benefit before opportunity costs $100,000 $100,000Opportunity cost of machineOpportunity cost of machine 60,00060,000Net financial benefitNet financial benefit $ 40,000 $ 40,000

RevenueRevenue $500,000 $500,000Costs:Costs: Outlay CostsOutlay Costs 400,000400,000 Financial benefit before opportunity costs Financial benefit before opportunity costs $100,000 $100,000Opportunity cost of machineOpportunity cost of machine 60,00060,000Net financial benefitNet financial benefit $ 40,000 $ 40,000

Sell machine for $50,000.Sell machine for $50,000.

Peach Juice Contribution margin is $60,000.Peach Juice Contribution margin is $60,000.

Produce Papaya Mango juice with projected sales of $500,000.Produce Papaya Mango juice with projected sales of $500,000.


Make-or-Buy DecisionsMake-or-Buy Decisions

Managers often must decide whether toManagers often must decide whether toproduce a product or service within theproduce a product or service within the

firm or purchase it from an outside supplier.firm or purchase it from an outside supplier.

Managers often must decide whether toManagers often must decide whether toproduce a product or service within theproduce a product or service within the

firm or purchase it from an outside supplier.firm or purchase it from an outside supplier.



Make or Buy DecisionsMake or Buy Decisions

Direct materialDirect material $ 60,000$ 60,000 $.06 $.06 Direct laborDirect labor 20,000 20,000 .02 .02 Variable factory overheadVariable factory overhead 40,000 40,000 .04 .04 Fixed factory overheadFixed factory overhead 80,000 80,000 .08 .08 Total costsTotal costs $200,000$200,000 $.20 $.20

Direct materialDirect material $ 60,000$ 60,000 $.06 $.06 Direct laborDirect labor 20,000 20,000 .02 .02 Variable factory overheadVariable factory overhead 40,000 40,000 .04 .04 Fixed factory overheadFixed factory overhead 80,000 80,000 .08 .08 Total costsTotal costs $200,000$200,000 $.20 $.20

Nantucket Nectars Nantucket Nectars Company’s Cost of Company’s Cost of Making 12-ounce BottlesMaking 12-ounce Bottles


Make-or-Buy ExampleMake-or-Buy Example

Another manufacturer offers to sellAnother manufacturer offers to sellNantucket the bottles for $.18.Nantucket the bottles for $.18.

Another manufacturer offers to sellAnother manufacturer offers to sellNantucket the bottles for $.18.Nantucket the bottles for $.18.

If the company buys the bottles, $50,000If the company buys the bottles, $50,000of fixed overhead would be eliminated.of fixed overhead would be eliminated.

If the company buys the bottles, $50,000If the company buys the bottles, $50,000of fixed overhead would be eliminated.of fixed overhead would be eliminated.

Should Nantucket make or buy the bottles?Should Nantucket make or buy the bottles?Should Nantucket make or buy the bottles?Should Nantucket make or buy the bottles?


Relevant Cost ComparisonRelevant Cost Comparison

Purchase costPurchase cost $180,000$180,000 $.18 $.18 Direct materialDirect material $ 60,000$ 60,000 $.06 $.06 Direct laborDirect labor 20,000 20,000 .02 .02 Variable overheadVariable overhead 40,000 40,000 .04 .04Fixed OH avoided byFixed OH avoided by not makingnot making 50,000 50,000 .05 .05 0 0 0 0Total relevant costsTotal relevant costs $170,000 $170,000 $.17$.17 $180,000 $180,000 $.18$.18Difference in favorDifference in favor of makingof making $ 10,000 $ 10,000 $.01$.01

TotalTotal Per BottlePer Bottle TotalTotal Per BottlePer Bottle

MakeMake BuyBuy


Make or Buy and the Use of FacilitiesMake or Buy and the Use of Facilities

Suppose Nantucket can use the releasedSuppose Nantucket can use the releasedfacilities in other manufacturing activitiesfacilities in other manufacturing activities

to produce a contribution to profits ofto produce a contribution to profits of$55,000, or can rent them out for $25,000.$55,000, or can rent them out for $25,000.

Suppose Nantucket can use the releasedSuppose Nantucket can use the releasedfacilities in other manufacturing activitiesfacilities in other manufacturing activities

to produce a contribution to profits ofto produce a contribution to profits of$55,000, or can rent them out for $25,000.$55,000, or can rent them out for $25,000.

What are the alternatives?What are the alternatives?What are the alternatives?What are the alternatives?


Make or Buy and the Use of FacilitiesMake or Buy and the Use of Facilities

Rent revenueRent revenue $ —$ — $ —$ — $ 25$ 25 $ —$ —

Contribution fromContribution from

other productsother products — — —— — — 55 55

Variable cost of bottlesVariable cost of bottles (170) (170) (180) (180) (180) (180) (180) (180)

Net relevant costsNet relevant costs $(170)$(170) $(180)$(180) $(155)$(155) $(125)$(125)

Rent revenueRent revenue $ —$ — $ —$ — $ 25$ 25 $ —$ —

Contribution fromContribution from

other productsother products — — —— — — 55 55

Variable cost of bottlesVariable cost of bottles (170) (170) (180) (180) (180) (180) (180) (180)

Net relevant costsNet relevant costs $(170)$(170) $(180)$(180) $(155)$(155) $(125)$(125)

MakeMake

Buy andBuy andleaveleave

facilitiesfacilitiesidleidle

Buy andBuy andrent outrent outfacilitiesfacilities

Buy and use Buy and use facilities facilities for other for other products products (000)(000)


Avoidable costs are costs that willAvoidable costs are costs that willnot continue if an ongoingnot continue if an ongoing

operation is changed or deleted.operation is changed or deleted.

Unavoidable costs are costs thatUnavoidable costs are costs thatcontinue even if an operation is halted.continue even if an operation is halted.

LearningLearningObjective 3Objective 3 Avoidable and Unavoidable CostsAvoidable and Unavoidable Costs

Common costs are costs of facilities and Common costs are costs of facilities and services that are shared by users.services that are shared by users.


GroceriesGroceries

General merchandiseGeneral merchandise

DrugsDrugs

Consider a discount department storeConsider a discount department storethat has three major departments:that has three major departments:

Department Store ExampleDepartment Store Example


SalesSales $1,900 $1,900 $1,000 $1,000 $800 $800 $100 $100Variable expensesVariable expenses 1,4201,420 800 800 560 560 60 60 Contribution marginContribution margin $ 480 (25%) $ 200 (20%) $240 (30%) $ 40 (40%) $ 480 (25%) $ 200 (20%) $240 (30%) $ 40 (40%)Fixed expenses:Fixed expenses: AvoidableAvoidable $ 265 $ 265 $ 150 $ 150 $100 $100 $ 15 $ 15 UnavoidableUnavoidable 180180 6060 100 100 20 20 Total fixed expensesTotal fixed expenses $ 445 $ 445 $ 210 $ 210 $200 $200 $ 35 $ 35Operating incomeOperating income $ 35$ $ 35$ (10) (10) $ 40 $ 40 $ 5 $ 5

SalesSales $1,900 $1,900 $1,000 $1,000 $800 $800 $100 $100Variable expensesVariable expenses 1,4201,420 800 800 560 560 60 60 Contribution marginContribution margin $ 480 (25%) $ 200 (20%) $240 (30%) $ 40 (40%) $ 480 (25%) $ 200 (20%) $240 (30%) $ 40 (40%)Fixed expenses:Fixed expenses: AvoidableAvoidable $ 265 $ 265 $ 150 $ 150 $100 $100 $ 15 $ 15 UnavoidableUnavoidable 180180 6060 100 100 20 20 Total fixed expensesTotal fixed expenses $ 445 $ 445 $ 210 $ 210 $200 $200 $ 35 $ 35Operating incomeOperating income $ 35$ $ 35$ (10) (10) $ 40 $ 40 $ 5 $ 5

DepartmentsDepartmentsGroceriesGroceries

GeneralGeneralMdse.Mdse. DrugsDrugs TotalTotal


($000)($000)


Assume further that the total assets investedAssume further that the total assets investedwould be unaffected by the decision.would be unaffected by the decision.

The vacated space would be idle andThe vacated space would be idle andthe unavoidable costs would continue.the unavoidable costs would continue.

Assume that the only alternatives to be considered Assume that the only alternatives to be considered are dropping or continuing the grocery department, are dropping or continuing the grocery department,

which has consistently shown an operating loss.which has consistently shown an operating loss.



SalesSales $1,900$1,900 $1,000$1,000 $900$900Variable expensesVariable expenses 1,420 1,420 800 800 620 620Contribution marginContribution margin $ 480$ 480 $ 200$ 200 $280$280AvoidableAvoidable fixed expensesfixed expenses 265 265 150 150 115 115Profit contribution toProfit contribution to common space andcommon space and other unavoidable costsother unavoidable costs $ 215$ 215 $ 50$ 50 $165$165Unavoidable expensesUnavoidable expenses 180 180 0 0 180 180Operating incomeOperating income $ 35$ 35 $ 50$ 50 $ (15)$ (15)

TotalTotalBeforeBeforeChangeChange

Effect ofEffect ofDroppingDroppingGroceriesGroceries

TotalTotalAfterAfter

ChangeChange

Store as a Whole ($000)Store as a Whole ($000)



Assume that the store could use the spaceAssume that the store could use the spacemade available by the dropping of groceriesmade available by the dropping of groceries

to expand the general merchandise department.to expand the general merchandise department.

This will increase sales by $50,000,This will increase sales by $50,000,generate a 30% contribution-margin,generate a 30% contribution-margin,

and have avoidable fixed costs of $70,000.and have avoidable fixed costs of $70,000.

$80,000 – $50,000 = $30,000$80,000 – $50,000 = $30,000



SalesSales $1,900$1,900 $1,000$1,000 $500$500 $1,400 $1,400Variable expensesVariable expenses 1,420 1,420 800 800 350350 970 970 Contribution marginContribution margin $ 480$ 480 $ 200$ 200 $150 $150 $ 430 $ 430AvoidableAvoidable fixed expensesfixed expenses 265 265 150 150 70 70 185 185Profit contribution toProfit contribution to common space andcommon space and other unavoidable costsother unavoidable costs $ 215$ 215 $ 50$ 50 $80 $80 $245 $245Unavoidable expensesUnavoidable expenses 180 180 0 0 00 180 180Operating incomeOperating income $ 35$ 35 $ 50$ 50 $80 $80 $ 65 $ 65

TotalTotalBeforeBeforeChangeChange

DropDropGroceriesGroceries

TotalTotalAfterAfter

ChangeChange

Store as a Whole ($000)Store as a Whole ($000)Expand Expand GeneralGeneral

MerchandiseMerchandise



Assume that the capacity of the facility is Assume that the capacity of the facility is determined by machine time, and thedetermined by machine time, and the

maximum capacity is 10,000 machine hours.maximum capacity is 10,000 machine hours.

Assume that the capacity of the facility is Assume that the capacity of the facility is determined by machine time, and thedetermined by machine time, and the

maximum capacity is 10,000 machine hours.maximum capacity is 10,000 machine hours.

A limiting factor or scarce resourceA limiting factor or scarce resourcerestricts or constrains the productionrestricts or constrains the production

or sale of a product or service.or sale of a product or service.

A limiting factor or scarce resourceA limiting factor or scarce resourcerestricts or constrains the productionrestricts or constrains the production

or sale of a product or service.or sale of a product or service.

LearningLearningObjective 4Objective 4 Optimal Use of Limited ResourcesOptimal Use of Limited Resources

The facility can produce 10 pairs of Air Court The facility can produce 10 pairs of Air Court Shoes or 5 pairs of Air Max shoes per hour.Shoes or 5 pairs of Air Max shoes per hour.

The facility can produce 10 pairs of Air Court The facility can produce 10 pairs of Air Court Shoes or 5 pairs of Air Max shoes per hour.Shoes or 5 pairs of Air Max shoes per hour.


Selling price per pairSelling price per pair $80$80 $120$120Variable costs per pair Variable costs per pair 60 60 84 84Contribution margin per pairContribution margin per pair $20$20 $ 36$ 36Contribution margin ratioContribution margin ratio 25% 25% 30% 30%

Air Air CourtCourt

AirAirMaxMax

Optimal Use of Limited ResourcesOptimal Use of Limited Resources


Which is more profitable?Which is more profitable?

If the limiting factor is demand, that is, pairsIf the limiting factor is demand, that is, pairsof shoes, the more profitable product is Air Max.of shoes, the more profitable product is Air Max.




The sale of a pair of Air Court The sale of a pair of Air Court shoes adds $20 to profit.shoes adds $20 to profit.

The sale of a pair of Air MaxThe sale of a pair of Air Maxshoes adds $36 to profit.shoes adds $36 to profit.

Air Max is the product with Air Max is the product with the higher contribution per unit.the higher contribution per unit.


Suppose that demand for either shoe would fill the Suppose that demand for either shoe would fill the plant’s capacity. Now, capacity is the limiting factor. plant’s capacity. Now, capacity is the limiting factor.


Which is more profitable?Which is more profitable?

If the limiting factor is capacity, If the limiting factor is capacity, the more profitable product is Air Court.the more profitable product is Air Court.



Air CourtAir Court$20 contribution margin per pair × 10,000 hours $20 contribution margin per pair × 10,000 hours

= = $2,000,000 contribution $2,000,000 contribution

Air Max:Air Max:$36 contribution margin per pair × 10,000 hours $36 contribution margin per pair × 10,000 hours

= = $1,800,000$1,800,000 contribution contribution



In retails stores, the limiting factor is often floor space. In retails stores, the limiting factor is often floor space. The focus is on products taking up less space orThe focus is on products taking up less space oron using the space for shorter periods of time.on using the space for shorter periods of time.

Retail stores seek faster inventory turnover Retail stores seek faster inventory turnover (the number of times the average (the number of times the average

inventory is sold per year).inventory is sold per year).



Retail PriceRetail Price $4.00 $4.00 $3.50 $3.50Costs of Merchandise and other variable costs Costs of Merchandise and other variable costs 3.003.00 3.00 3.00 Contribution to profit per unitContribution to profit per unit $1.00 (25%) $ .50 (14%) $1.00 (25%) $ .50 (14%) Units sold per yearUnits sold per year 10,000 22,000 10,000 22,000Total contribution to profit, assuming theTotal contribution to profit, assuming thesame space allotment in both storessame space allotment in both stores $10,000 $10,000 11,000 11,000

RegularRegularDepartmDepartm

ententStoreStore

DiscountDiscountDepartmDepartmentent

StoreStore

Faster inventory turnover makes the Faster inventory turnover makes the same product a more profitable use of same product a more profitable use of space in a discount store.space in a discount store.

Faster inventory turnover makes the Faster inventory turnover makes the same product a more profitable use of same product a more profitable use of space in a discount store.space in a discount store.


Joint Product CostsJoint Product Costs

Joint products have relatively significant sales values.Joint products have relatively significant sales values.Joint products have relatively significant sales values.Joint products have relatively significant sales values.

They are not separately identifiable asThey are not separately identifiable asindividual products until their split-off point.individual products until their split-off point.

They are not separately identifiable asThey are not separately identifiable asindividual products until their split-off point.individual products until their split-off point.

The split-off point is that juncture ofThe split-off point is that juncture ofmanufacturing where the joint productsmanufacturing where the joint products

become individually identifiable.become individually identifiable.

The split-off point is that juncture ofThe split-off point is that juncture ofmanufacturing where the joint productsmanufacturing where the joint products

become individually identifiable.become individually identifiable.



Separable costs are any costsSeparable costs are any costsbeyond the split-off point.beyond the split-off point.

Separable costs are any costsSeparable costs are any costsbeyond the split-off point.beyond the split-off point.

Joint costs are the costs of manufacturingJoint costs are the costs of manufacturingjoint products before the split-off point.joint products before the split-off point.

Joint costs are the costs of manufacturingJoint costs are the costs of manufacturingjoint products before the split-off point.joint products before the split-off point.



Suppose Dow Chemical Company producesSuppose Dow Chemical Company producestwo chemical products, X and Y, astwo chemical products, X and Y, asa result of a particular joint process.a result of a particular joint process.

Suppose Dow Chemical Company producesSuppose Dow Chemical Company producestwo chemical products, X and Y, astwo chemical products, X and Y, asa result of a particular joint process.a result of a particular joint process.

The joint processing cost is $100,000.The joint processing cost is $100,000.The joint processing cost is $100,000.The joint processing cost is $100,000.

Both products are sold to the petroleumBoth products are sold to the petroleumindustry to be used as ingredients of gasoline.industry to be used as ingredients of gasoline.

Both products are sold to the petroleumBoth products are sold to the petroleumindustry to be used as ingredients of gasoline.industry to be used as ingredients of gasoline.



1 million liters of X at a1 million liters of X at aselling price of $.09 = $90,000selling price of $.09 = $90,000

1 million liters of X at a1 million liters of X at aselling price of $.09 = $90,000selling price of $.09 = $90,000

500,000 liters of Y at a500,000 liters of Y at aselling price of $.06 = $30,000selling price of $.06 = $30,000

500,000 liters of Y at a500,000 liters of Y at aselling price of $.06 = $30,000selling price of $.06 = $30,000

Total sales value atTotal sales value atsplit-off is $120,000split-off is $120,000Total sales value atTotal sales value atsplit-off is $120,000split-off is $120,000

Joint-processingJoint-processingcost is $100,000cost is $100,000Joint-processingJoint-processingcost is $100,000cost is $100,000

Split-off pointSplit-off point



Illustration of Sell or Process FurtherIllustration of Sell or Process Further

Suppose the 500,000 liters of Y can beSuppose the 500,000 liters of Y can beprocessed further and sold to theprocessed further and sold to the plastics industry as product YA.plastics industry as product YA.

Suppose the 500,000 liters of Y can beSuppose the 500,000 liters of Y can beprocessed further and sold to theprocessed further and sold to the plastics industry as product YA.plastics industry as product YA.

The additional processing cost wouldThe additional processing cost wouldbe $.08 per liter for manufacturingbe $.08 per liter for manufacturingand distribution, a total of $40,000.and distribution, a total of $40,000.

The additional processing cost wouldThe additional processing cost wouldbe $.08 per liter for manufacturingbe $.08 per liter for manufacturingand distribution, a total of $40,000.and distribution, a total of $40,000.

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


Illustration of Sell or Process FurtherIllustration of Sell or Process Further

RevenuesRevenues $30,000$30,000 $80,000$80,000 $50,000$50,000Separable costsSeparable costs beyond split-offbeyond split-off @ $.08@ $.08 – – 40,000 40,000 40,000 40,000Income effectsIncome effects $30,000$30,000 $40,000$40,000 $10,000$10,000

RevenuesRevenues $30,000$30,000 $80,000$80,000 $50,000$50,000Separable costsSeparable costs beyond split-offbeyond split-off @ $.08@ $.08 – – 40,000 40,000 40,000 40,000Income effectsIncome effects $30,000$30,000 $40,000$40,000 $10,000$10,000

Sell atSell atSplit-offSplit-off

as Yas Y

ProcessProcessFurther andFurther andSell as YASell as YA DifferenceDifference


Equipment ReplacementEquipment Replacement

The book value of equipment is notThe book value of equipment is nota relevant consideration in decidinga relevant consideration in decidingwhether to replace the equipment.whether to replace the equipment.

The book value of equipment is notThe book value of equipment is nota relevant consideration in decidinga relevant consideration in decidingwhether to replace the equipment.whether to replace the equipment.

Because it is a past, not a future cost.Because it is a past, not a future cost.Because it is a past, not a future cost.Because it is a past, not a future cost.



Book Value of Old EquipmentBook Value of Old Equipment

Depreciation is the periodic allocationDepreciation is the periodic allocationof the cost of equipment.of the cost of equipment.

Depreciation is the periodic allocationDepreciation is the periodic allocationof the cost of equipment.of the cost of equipment.

The equipment’s The equipment’s book valuebook value (or (or net booknet book valuevalue))is the original cost less accumulated depreciation.is the original cost less accumulated depreciation.

The equipment’s The equipment’s book valuebook value (or (or net booknet book valuevalue))is the original cost less accumulated depreciation.is the original cost less accumulated depreciation.


Book Value of Old EquipmentBook Value of Old Equipment

Suppose a $10,000 machine with a 10-year lifeSuppose a $10,000 machine with a 10-year lifespan has depreciation of $1,000 per year.span has depreciation of $1,000 per year.

Suppose a $10,000 machine with a 10-year lifeSuppose a $10,000 machine with a 10-year lifespan has depreciation of $1,000 per year.span has depreciation of $1,000 per year.

What is the book value at the end of 6 years?What is the book value at the end of 6 years?What is the book value at the end of 6 years?What is the book value at the end of 6 years?

Original costOriginal cost $10,000$10,000Accumulated depreciation (6 × $1,000)Accumulated depreciation (6 × $1,000) 6,000 6,000

Book valueBook value $ 4,000$ 4,000

Original costOriginal cost $10,000$10,000Accumulated depreciation (6 × $1,000)Accumulated depreciation (6 × $1,000) 6,000 6,000

Book valueBook value $ 4,000$ 4,000


Keep or Replace the Old Machine?Keep or Replace the Old Machine?

Original costOriginal cost $10,000$10,000 $8,000$8,000Useful life in yearsUseful life in years 10 10 44Current age in yearsCurrent age in years 6 6 00Useful life remaining in yearsUseful life remaining in years 4 4 44Accumulated depreciationAccumulated depreciation $ 6,000$ 6,000 00Book valueBook value $ 4,000$ 4,000 N/A N/ADisposal value (in cash) nowDisposal value (in cash) now $ 2,500$ 2,500 N/A N/ADisposal value in 4 yearsDisposal value in 4 years 0 0 00Annual cash operating costsAnnual cash operating costs $ 5,000$ 5,000 $3,000$3,000

Original costOriginal cost $10,000$10,000 $8,000$8,000Useful life in yearsUseful life in years 10 10 44Current age in yearsCurrent age in years 6 6 00Useful life remaining in yearsUseful life remaining in years 4 4 44Accumulated depreciationAccumulated depreciation $ 6,000$ 6,000 00Book valueBook value $ 4,000$ 4,000 N/A N/ADisposal value (in cash) nowDisposal value (in cash) now $ 2,500$ 2,500 N/A N/ADisposal value in 4 yearsDisposal value in 4 years 0 0 00Annual cash operating costsAnnual cash operating costs $ 5,000$ 5,000 $3,000$3,000

OldOldMachineMachine

ReplacementReplacementMachineMachine


Relevance of Equipment DataRelevance of Equipment Data

Book value of old equipmentBook value of old equipment Disposal value of old equipmentDisposal value of old equipment

Gain or loss on disposalGain or loss on disposal Cost of new equipmentCost of new equipment

Book value of old equipmentBook value of old equipment Disposal value of old equipmentDisposal value of old equipment

Gain or loss on disposalGain or loss on disposal Cost of new equipmentCost of new equipment

A sunk cost is a cost already incurred and is A sunk cost is a cost already incurred and is irrelevant to the decision-making process.irrelevant to the decision-making process.

A sunk cost is a cost already incurred and is A sunk cost is a cost already incurred and is irrelevant to the decision-making process.irrelevant to the decision-making process.


Relevance of Equipment DataRelevance of Equipment Data

The book value of old equipment is irrelevant The book value of old equipment is irrelevant because it is a past (historical) cost.because it is a past (historical) cost.

The book value of old equipment is irrelevant The book value of old equipment is irrelevant because it is a past (historical) cost.because it is a past (historical) cost.

Therefore, depreciation onTherefore, depreciation onold equipment is irrelevant.old equipment is irrelevant.Therefore, depreciation onTherefore, depreciation onold equipment is irrelevant.old equipment is irrelevant.


Disposal Value of Old EquipmentDisposal Value of Old Equipment

The disposal value of old equipmentThe disposal value of old equipmentis relevant because it is an expectedis relevant because it is an expected

future inflow that usually differsfuture inflow that usually differsamong alternatives.among alternatives.

The disposal value of old equipmentThe disposal value of old equipmentis relevant because it is an expectedis relevant because it is an expected

future inflow that usually differsfuture inflow that usually differsamong alternatives.among alternatives.


Gain or Loss on DisposalGain or Loss on Disposal

This is the difference betweenThis is the difference betweenbook value and disposal value.book value and disposal value.This is the difference betweenThis is the difference betweenbook value and disposal value.book value and disposal value.

It is a meaningless combination of irrelevant It is a meaningless combination of irrelevant (book value) and relevant items (disposal value).(book value) and relevant items (disposal value).

It is a meaningless combination of irrelevant It is a meaningless combination of irrelevant (book value) and relevant items (disposal value).(book value) and relevant items (disposal value).

It is best to think of each separately.It is best to think of each separately.It is best to think of each separately.It is best to think of each separately.


Cost of New EquipmentCost of New Equipment

The cost of new equipment is relevantThe cost of new equipment is relevantbecause it is an expected future outflowbecause it is an expected future outflow

that will differ among alternatives.that will differ among alternatives.

The cost of new equipment is relevantThe cost of new equipment is relevantbecause it is an expected future outflowbecause it is an expected future outflow

that will differ among alternatives.that will differ among alternatives.


Cost ComparisonCost Comparison

Cash operating costsCash operating costs $20,000$20,000 $12,000$12,000 $8,000 $8,000Old equipment (book value):Old equipment (book value): Depreciation, orDepreciation, or 4,000 4,000 –– –– Lump-sum write-offLump-sum write-off –– 4,000 4,000 ––Disposal valueDisposal value –– (2,500) (2,500) 2,500 2,500New machineNew machine acquisition costacquisition cost –– 8,000 8,000 (8,000) (8,000)Total costsTotal costs $24,000$24,000 $21,500$21,500 $2,500 $2,500

Cash operating costsCash operating costs $20,000$20,000 $12,000$12,000 $8,000 $8,000Old equipment (book value):Old equipment (book value): Depreciation, orDepreciation, or 4,000 4,000 –– –– Lump-sum write-offLump-sum write-off –– 4,000 4,000 ––Disposal valueDisposal value –– (2,500) (2,500) 2,500 2,500New machineNew machine acquisition costacquisition cost –– 8,000 8,000 (8,000) (8,000)Total costsTotal costs $24,000$24,000 $21,500$21,500 $2,500 $2,500

DifferenceDifferenceKeepKeep ReplaceReplaceFour Years TogetherFour Years Together


Irrelevant or Misspecified CostsIrrelevant or Misspecified Costs

The ability to recognize irrelevant costs The ability to recognize irrelevant costs is important to decision makers.is important to decision makers.

The ability to recognize irrelevant costs The ability to recognize irrelevant costs is important to decision makers.is important to decision makers.




Suppose General Dynamics has 100Suppose General Dynamics has 100obsolete aircraft parts in its inventory.obsolete aircraft parts in its inventory.

Suppose General Dynamics has 100Suppose General Dynamics has 100obsolete aircraft parts in its inventory.obsolete aircraft parts in its inventory.

The original manufacturing costThe original manufacturing costof these parts was $100,000.of these parts was $100,000.

The original manufacturing costThe original manufacturing costof these parts was $100,000.of these parts was $100,000.

General Dynamics can remachine the parts for $30,000 General Dynamics can remachine the parts for $30,000 and then sell them for $50,000, or scrap them for $5,000.and then sell them for $50,000, or scrap them for $5,000.General Dynamics can remachine the parts for $30,000 General Dynamics can remachine the parts for $30,000

and then sell them for $50,000, or scrap them for $5,000.and then sell them for $50,000, or scrap them for $5,000.



DifferenceDifferenceRemachineRemachine ScrapScrap

Expected future revenueExpected future revenue $ 50,000$ 50,000 $ 5,000$ 5,000 $45,000$45,000

Expected future costsExpected future costs 30,000 30,000 0 0 30,000 30,000

Relevant excess ofRelevant excess of

revenue over costsrevenue over costs $ 20,000$ 20,000 $ 5,000$ 5,000 $15,000$15,000

Accumulated historicalAccumulated historical

inventory costinventory cost** 100,000 100,000 100,000 100,000 0 0

Net loss on projectNet loss on project $(80,000)$(80,000) $ (95,000)$ (95,000) $15,000$15,000

* * Irrelevant because it is unaffected by the decision.Irrelevant because it is unaffected by the decision.

Expected future revenueExpected future revenue $ 50,000$ 50,000 $ 5,000$ 5,000 $45,000$45,000

Expected future costsExpected future costs 30,000 30,000 0 0 30,000 30,000

Relevant excess ofRelevant excess of

revenue over costsrevenue over costs $ 20,000$ 20,000 $ 5,000$ 5,000 $15,000$15,000

Accumulated historicalAccumulated historical

inventory costinventory cost** 100,000 100,000 100,000 100,000 0 0

Net loss on projectNet loss on project $(80,000)$(80,000) $ (95,000)$ (95,000) $15,000$15,000

* * Irrelevant because it is unaffected by the decision.Irrelevant because it is unaffected by the decision.



There are two major ways to go wrong There are two major ways to go wrong when using unit costs in decision making:when using unit costs in decision making:

There are two major ways to go wrong There are two major ways to go wrong when using unit costs in decision making:when using unit costs in decision making:

1)1) including irrelevant costsincluding irrelevant costs1)1) including irrelevant costsincluding irrelevant costs

2)2) comparing unit costs not computedcomparing unit costs not computed

on the same volume basison the same volume basis2)2) comparing unit costs not computedcomparing unit costs not computed

on the same volume basison the same volume basis



Assume that a new $100,000 machine withAssume that a new $100,000 machine witha five-year life can produce 100,000 unitsa five-year life can produce 100,000 units

a year at a variable cost of $1 per unit,a year at a variable cost of $1 per unit,as opposed to a variable cost per unitas opposed to a variable cost per unit

of $1.50 with an old machine.of $1.50 with an old machine.

Assume that a new $100,000 machine withAssume that a new $100,000 machine witha five-year life can produce 100,000 unitsa five-year life can produce 100,000 units

a year at a variable cost of $1 per unit,a year at a variable cost of $1 per unit,as opposed to a variable cost per unitas opposed to a variable cost per unit

of $1.50 with an old machine.of $1.50 with an old machine.

Is the new machine a worthwhile acquisition?Is the new machine a worthwhile acquisition?Is the new machine a worthwhile acquisition?Is the new machine a worthwhile acquisition?



UnitsUnits 100,000 100,000 100,000 100,000Variable cost Variable cost $150,000$150,000 $100,000 $100,000 Straight-line depreciationStraight-line depreciation 0 0 20,000 20,000Total relevant costsTotal relevant costs $ 45,000$ 45,000 $120,000$120,000Unit relevant costsUnit relevant costs $ 1.50$ 1.50 $ 1.20$ 1.20

UnitsUnits 100,000 100,000 100,000 100,000Variable cost Variable cost $150,000$150,000 $100,000 $100,000 Straight-line depreciationStraight-line depreciation 0 0 20,000 20,000Total relevant costsTotal relevant costs $ 45,000$ 45,000 $120,000$120,000Unit relevant costsUnit relevant costs $ 1.50$ 1.50 $ 1.20$ 1.20

Old MachineOld MachineNew MachineNew Machine



It appears that the new machineIt appears that the new machinewill reduce costs by $.30 per unit.will reduce costs by $.30 per unit.It appears that the new machineIt appears that the new machinewill reduce costs by $.30 per unit.will reduce costs by $.30 per unit.

However, if the expected volume is onlyHowever, if the expected volume is only30,000 units per year, the unit costs30,000 units per year, the unit costschange in favor of the old machine.change in favor of the old machine.

However, if the expected volume is onlyHowever, if the expected volume is only30,000 units per year, the unit costs30,000 units per year, the unit costschange in favor of the old machine.change in favor of the old machine.


UnitsUnits 30,000 30,000 30,000 30,000Variable costsVariable costs $45,000$45,000 $30,000 $30,000 Straight-line depreciationStraight-line depreciation 0 0 20,000 20,000Total relevant costsTotal relevant costs $45,000$45,000 $50,000$50,000Unit relevant costsUnit relevant costs $1.50 $1.50 $1.6667$1.6667

UnitsUnits 30,000 30,000 30,000 30,000Variable costsVariable costs $45,000$45,000 $30,000 $30,000 Straight-line depreciationStraight-line depreciation 0 0 20,000 20,000Total relevant costsTotal relevant costs $45,000$45,000 $50,000$50,000Unit relevant costsUnit relevant costs $1.50 $1.50 $1.6667$1.6667

Old MachineOld MachineNew MachineNew Machine



Decision Making and Performance Decision Making and Performance

EvaluationEvaluation

To motivate managers to make the right choice, To motivate managers to make the right choice, the method used to evaluate performance should the method used to evaluate performance should

be consistent with the decision model.be consistent with the decision model.

To motivate managers to make the right choice, To motivate managers to make the right choice, the method used to evaluate performance should the method used to evaluate performance should

be consistent with the decision model.be consistent with the decision model.


Consider the replacement decision where replacing aConsider the replacement decision where replacing amachine has a $2,500 advantage over keeping it.machine has a $2,500 advantage over keeping it.

Consider the replacement decision where replacing aConsider the replacement decision where replacing amachine has a $2,500 advantage over keeping it.machine has a $2,500 advantage over keeping it.




Cash operatingCash operating costscosts $5,000$5,000 $3,000$3,000 $5,000$5,000 $3,000$3,000DepreciationDepreciation 1,000 1,000 2,000 2,000 1,000 1,000 2,000 2,000Loss on disposalLoss on disposal ($4,000 – $2,500)($4,000 – $2,500) 0 0 $1,500$1,500 0 0 0 0 Total chargesTotal charges against revenueagainst revenue $6,000$6,000 $6,500$6,500 $6,000 $6,000 $5,000$5,000

Cash operatingCash operating costscosts $5,000$5,000 $3,000$3,000 $5,000$5,000 $3,000$3,000DepreciationDepreciation 1,000 1,000 2,000 2,000 1,000 1,000 2,000 2,000Loss on disposalLoss on disposal ($4,000 – $2,500)($4,000 – $2,500) 0 0 $1,500$1,500 0 0 0 0 Total chargesTotal charges against revenueagainst revenue $6,000$6,000 $6,500$6,500 $6,000 $6,000 $5,000$5,000

KeepKeep ReplaceReplace KeepKeep ReplaceReplaceYear 1Year 1 Years 2, 3, and 4 Years 2, 3, and 4




If the machine is kept rather than replaced,If the machine is kept rather than replaced,first-year costs will be $500 lowerfirst-year costs will be $500 lower($6,500 – $6,000), and first-year($6,500 – $6,000), and first-year

income will be $500 higher.income will be $500 higher.

If the machine is kept rather than replaced,If the machine is kept rather than replaced,first-year costs will be $500 lowerfirst-year costs will be $500 lower($6,500 – $6,000), and first-year($6,500 – $6,000), and first-year

income will be $500 higher.income will be $500 higher.

Performance is often measured by accounting Performance is often measured by accounting income, consider the accounting incomeincome, consider the accounting income

in the first year after replacement in the first year after replacement compared with that in years 2, 3, and 4.compared with that in years 2, 3, and 4.

Performance is often measured by accounting Performance is often measured by accounting income, consider the accounting incomeincome, consider the accounting income

in the first year after replacement in the first year after replacement compared with that in years 2, 3, and 4.compared with that in years 2, 3, and 4.


End of Chapter 6End of Chapter 6

The EndThe End

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