Relevant Information for Special Decisions Chapter 4.

Relevant Information for Special Decisions

Chapter 4

Copyright © 2003 McGraw-Hill Ryerson Limited, Canada4-2

Relevant Information

Relevant Informationdiffers between the alternatives

under consideration and isfuture oriented.

Relevant Informationdiffers between the alternatives

under consideration and isfuture oriented.

Sunk Costhas already been incurred in apast transaction, and cannot beavoided. Not a relevant cost.

Sunk Costhas already been incurred in apast transaction, and cannot beavoided. Not a relevant cost.


Relevant Revenues and Costs

Relevant Revenuesare expected future revenues that

differ between the alternativesunder consideration.

Relevant Revenuesare expected future revenues that

differ between the alternativesunder consideration.

Relevant Costsare avoidable costs that can be

eliminated by taking a specifiedcourse of action.

Relevant Costsare avoidable costs that can be

eliminated by taking a specifiedcourse of action.


Cost Avoidance is Related to a Cost Hierarchy

Unit-levelActivities

Batch-levelActivities

Product-levelActivities

Facility-levelActivities

Avoided by eliminating oneunit of product.

Avoided when a batch ofwork is eliminated.

Avoided if a product lineis eliminated.

Some costs may be avoidedwhen a product line is

eliminated.


Relevance is an Independent Concept

The management of Better Bakery is trying to decide whether the production of cakes or

pies would be more profitable.



The cakes will be distributed under a nationally advertised label and requires a franchise fee. The pies will be sold under Better Bakery’s own name and additional

advertising is necessary.

For either alternative we will hire a production supervisor at a cost of $25,000.

Which costs are relevant?



We could avoid 50¢ ofmaterials by choosing to

make cakes instead of pies!So, this is a relevant cost.

We could avoid 50¢ ofmaterials by choosing to

make cakes instead of pies!So, this is a relevant cost.



Labour costs are the sameunder either alternative, so they

are not relevant. The samefor the supervisor’s salary.

Labour costs are the sameunder either alternative, so they

are not relevant. The samefor the supervisor’s salary.



We canavoid the

franchise feeif we make

pies!

We canavoid the

franchise feeif we make

pies!

I know. But, we can avoidthe advertising costs if we

make cakes.

I know. But, we can avoidthe advertising costs if we

make cakes.


Opportunity Costs are Relevant

Opportunity CostThe sacrifice of a potential benefitassociated with a lost opportunity.

Opportunity CostThe sacrifice of a potential benefitassociated with a lost opportunity.

By attending college, you miss the opportunity to

earn a salary by working full time.


Quantitative Versus Qualitative Characteristics of Decision Making

Quantatative Characteristics

Numbers in decision making subject to mathematical manipulation, such as the dollar amounts of

revenues and expenses.

Quantatative Characteristics

Numbers in decision making subject to mathematical manipulation, such as the dollar amounts of

revenues and expenses.

Qualatative Characteristics

Nonquantifiable features, such as company reputation, welfare of employees, and

customer satisfaction, that can be affected by certain decisions.

Qualatative Characteristics

Nonquantifiable features, such as company reputation, welfare of employees, and

customer satisfaction, that can be affected by certain decisions.


Relevant Information and Decision Making Five types of special decisions are

frequently encountered in business practices: Special order Outsourcing Segment elimination Asset replacement Scarce resource allocation


Special Order Decisions

Stoerner Office Products manufactures copy machines, computers, and printers.

The company expects to sell 2,000 printers next year, and will manufacture the printers in 10 batches of 200 printers per batch.

The accountants at Stoerner provide us with the cost information on the next slide.


Each printer

cost $329.25 $658,500 2,000



Each printer sells for $360. Stoerner receives a special order for 200

printers at a price of $250 each. The company has excess capacity and

could manufacture the additional printers with no change in its other activities.

Should Stoerner accept the order?



Relevant Information for Special Order of 200 Printers

Differential Revenue ($250 × 200 units) 50,000$ Avoidable Unit-Level Costs ($180 × 200 units) (36,000) Avoidable Batch-Level Costs ($2,200 × 1 batch) (2,200) Contribution to Income 11,800$

Product-level and facility-level costs will beincurred even if the special order is rejected.Product-level and facility-level costs will be

incurred even if the special order is rejected.


Relevance and the Decision Context

Look what would happen if Stoerner reduces its selling price to existing customers.


Relevance and the Decision Context

What do you think Stoerner should do?


Outsourcing Decision

It may be possible for a company to purchase a product or service at a price

below what it would cost to make the product or provide the service.

Let’s see how this works at Stoerner.

Printer Supply of America



A supplier has offered to sell an unlimited supply of printers to Stoerner at a price of $240 each.

Recall that it currently cost Stoerner $329.25 for each printer manufactured.

Should Stoerner accept this proposal?

Printer Supply of America



These costs may be avoided by Stoerner if the printer is purchased from the supplier rather than manufactured.

Relevant Cost - Outsourcing 2,000 Printers

Unit-Level Costs ($180 × 2,000) 360,000$ Batch-Level Costs ($2,200 × 10 batches) 22,000 Product-Level Costs 77,300 Total Relevant Cost 459,300$

Relevant Unit Cost = $459,300 ÷ 2,000 = $229.65Relevant Unit Cost = $459,300 ÷ 2,000 = $229.65



Unit-Level Costs ($180 × 2,000) 360,000$ Batch-Level Costs ($2,200 × 10 batches) 22,000 Product-Level Costs 77,300 Total Relevant Cost 459,300$

Relevant Unit Cost = $459,300 ÷ 2,000 = $229.65Relevant Unit Cost = $459,300 ÷ 2,000 = $229.65


These costs may be avoided by Gates if the printer is purchased from the supplier rather than manufactured.Since the relevant cost of production is below the

purchase price of the printers, the quantitativeanalysis suggests that Stoerner Gates should continue to

make the printers.

Since the relevant cost of production is below thepurchase price of the printers, the quantitative

analysis suggests that Stoerner Gates should continue tomake the printers.



The accountant at Stoerner determined that if we stopped manufacturing printers, we could use the free space for warehousing finished goods inventory.

The company could save $40,000 per year that it is currently spending to rent warehouse.

Would this change your decision about outsourcing?



Total relevant cost $ 459,300Warehouse rent saved 40,000New total relevant cost 499,300Total printers outsourced 2,000Cost per unit $ 249.65

Total relevant cost $ 459,300Warehouse rent saved 40,000New total relevant cost 499,300Total printers outsourced 2,000Cost per unit $ 249.65

Since the relevant unit cost is above the purchaseprice of $240.00, Stoerner should outsource the printers.

Since the relevant unit cost is above the purchaseprice of $240.00, Stoerner should outsource the printers.


Evaluating the Effect of Growth in the Level of Production

If Stoerner sold 3,000 units per year, would outsourcing still be acceptable?


Unit-Level Costs ($180 × 3,000) 540,000$ Batch-Level Costs ($2,200 × 15 batches) 33,000 Product-Level Costs 77,300 Opportunity Cost 40,000 Total Relevant Cost 690,300$

Relevant unit cost = $690,300 ÷ 3,000 = $230.10 Relevant unit cost = $690,300 ÷ 3,000 = $230.10


Qualitative Features

The reliability of suppliersis a critically important

consideration in theoutsourcing decision.

The reliability of suppliersis a critically important

consideration in theoutsourcing decision.

Outsourcing usuallyinvolves employee

displacement.

Outsourcing usuallyinvolves employee

displacement.


Decisions to Eliminate Segments

When accounting reports indicate that a particular segment is operating at a net

loss, management must carefully consider the elimination of that segment.

The copier segment of Stoerner has been reporting losses. The most recent financial information is shown on the next slide.

The copier segment of Stoerner has been reporting losses. The most recent financial information is shown on the next slide.



Projected Revenues and Costs by SegmentCopiers Computers Printers Total

Projected Revenues 550,000$ 850,000$ 780,000$ 2,180,000$ Projected Costs: Unit-Level Costs: Materials Costs (120,000) (178,000) (180,000) (478,000) Labour Costs (160,000) (202,000) (165,000) (527,000) Overhead (30,800) (20,000) (15,000) (65,800) Batch-Level Costs (21,000) (34,000) (22,000) (77,000) Product-Level Costs (62,000) (67,800) (77,300) (207,100) Facility-Level Costs Segment-Level (94,200) (105,200) (97,700) (297,100) Corporate-Level (84,250) (106,750) (101,500) (292,500) Projected Profit (Loss) (22,250)$ 136,250$ 121,500$ 235,500$



What happens to existing costs if Stoerner eliminates the copier division?

Allocated corporate-levelfacility costs would beincurred even if Gates

stopped making copiers.

Allocated corporate-levelfacility costs would beincurred even if Gates

stopped making copiers.

Amortization is a sunkcost and can not be

avoided.

Amortization is a sunkcost and can not be

avoided.

Many segment-level,product-level, batch-level,

and unit-level costs can be avoidedif the copier division is eliminated.

Many segment-level,product-level, batch-level,

and unit-level costs can be avoidedif the copier division is eliminated.



The copier segment contributes $62,000 per year to Stoerner

profitability.

If the segment is eliminated,

profitability would decline by $62,000.

Relevant Revenue and Cost Data for Copier Segment

CopiersProjected Revenues 550,000$ Projected Costs: Unit-Level Costs: Materials Costs (120,000) Labour Costs (160,000) Overhead (30,800) Batch-Level Costs (21,000) Product-Level Costs (62,000) Facility-Level Costs Segment-Level (94,200) Projected Profit (Loss) 62,000$

Relevant Revenue and Cost Data for Copier Segment

CopiersProjected Revenues 550,000$ Projected Costs: Unit-Level Costs: Materials Costs (120,000) Labour Costs (160,000) Overhead (30,800) Batch-Level Costs (21,000) Product-Level Costs (62,000) Facility-Level Costs Segment-Level (94,200) Projected Profit (Loss) 62,000$





With the copier segment, total projected profit was$235,500. If the segment is eliminated, total projected

profit will be only $173,500.

With the copier segment, total projected profit was$235,500. If the segment is eliminated, total projected

profit will be only $173,500.


Relevant Information for Special Decisions

X = look for avoidable costs in this category.


Equipment Replacement Decision

Stoerner Office Products is considering replacing an older machine with a new,

more efficient machine. The new machine will substantially reduce annual operating

costs.Other information about the machines is

shown on the next screen.



Old Machine

New Machine

Original Cost 90,000$ 29,000$ Accum. Amortization (33,000) Book Value 57,000

Market Value 14,000 Salvage Value (in 5 yrs.) 2,000 4,000 Annual Amortization 11,000

$9,000 x 5 years$9,000 x 5 years$4,500 x 5 years$4,500 x 5 years


Old Machine

New Machine

Opportunity Cost 14,000$ 29,000$ Salvage Value (2,000) (4,000) Operating Expenses 45,000 22,500

57,000$ 47,500$

The original cost of the old machine, its book value,accumulated amortization, and annual amortizationexpense are all sunk costs and should be ignored.

The original cost of the old machine, its book value,accumulated amortization, and annual amortizationexpense are all sunk costs and should be ignored.


The relevant costs for the two machines are . . .


Old Machine

New Machine

Opportunity Cost 14,000$ 29,000$ Salvage Value (2,000) (4,000) Operating Expenses 45,000 22,500

57,000$ 47,500$

Stoerner should acquire the new machinebecause it produces the lower relevant cost.Stoerner should acquire the new machine

because it produces the lower relevant cost.


The relevant costs for the two machines are . . .


End of Chapter 4

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Relevant Information for Special Decisions Chapter 4.

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