Week7-ProductionDecisions

©2005 Prentice Hall Business Publishing, ©2005 Prentice Hall Business Publishing, Introduction to Management AccountingIntroduction to Management Accounting 13/e,13/e, Horngren/Sundem/Stratton Horngren/Sundem/Stratton 6 - 6 - 11

Relevant Relevant

InformationInformation

and Decision and Decision

Making:Making:

Production DecisionsProduction DecisionsChapter 6Chapter 6

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 6 - 2

Opportunity, Outlay, and Opportunity, Outlay, and Differential CostsDifferential Costs

Incremental cost includes all of the costs of theother alternative plus some additional costs.

Incremental cost includes all of the costs of theother alternative plus some additional costs.

Differential cost (or revenue) is the difference intotal cost (or revenue) between two alternatives.Differential cost (or revenue) is the difference intotal cost (or revenue) between two alternatives.


Opportunity, Outlay, and Opportunity, Outlay, and Differential CostsDifferential Costs

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

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

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


Make-or-Buy DecisionsMake-or-Buy Decisions

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

firm or purchase it from an outside supplier.

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

firm or purchase it from an outside supplier.


Make-or-Buy ExampleMake-or-Buy Example

Direct material $ 60,000 $.06Direct labour 20,000 .02Variable overhead 40,000 .04Fixed overhead 80,000 .08Total costs $200,000 $.20

Direct material $ 60,000 $.06Direct labour 20,000 .02Variable overhead 40,000 .04Fixed overhead 80,000 .08Total costs $200,000 $.20

Nantucket Nectars CompanyCost of Making 12-ounce Bottles

Total Cost for1,000,000 bottles

Cost perbottle


Make-or-Buy ExampleMake-or-Buy Example

Another manufacturer offers to sellNantucket the same part for $.18.Another manufacturer offers to sellNantucket the same part for $.18.

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

Should Nantucket make or buy the part?Should Nantucket make or buy the part?


Relevant Cost ComparisonRelevant Cost Comparison

Purchase cost $180,000 $.18Direct material $ 60,000 $.06Direct labour 20,000 .02Variable overhead 40,000 .04Fixed OH – unavoidable 30,000 .03 30,000 .03Fixed OH avoided by not making 50,000 .05 0 0Total costs $200,000 $.20 $210,000 $.21Difference in favour of making $ 10,000 $.01

Purchase cost $180,000 $.18Direct material $ 60,000 $.06Direct labour 20,000 .02Variable overhead 40,000 .04Fixed OH – unavoidable 30,000 .03 30,000 .03Fixed OH avoided by not making 50,000 .05 0 0Total costs $200,000 $.20 $210,000 $.21Difference in favour of making $ 10,000 $.01

Total Per Bottle Total Per Bottle

Make Buy


Relevant Cost ComparisonRelevant Cost Comparison

Purchase cost $180,000 $.18Direct material $ 60,000 $.06Direct labour 20,000 .02Variable overhead 40,000 .04

Fixed OH avoided by not making 50,000 .05 0 0Total relevant costs $170,000 $.17 $180,000 $.18Difference in favour of making $ 10,000 $.01

Purchase cost $180,000 $.18Direct material $ 60,000 $.06Direct labour 20,000 .02Variable overhead 40,000 .04

Fixed OH avoided by not making 50,000 .05 0 0Total relevant costs $170,000 $.17 $180,000 $.18Difference in favour of making $ 10,000 $.01

Total Per Bottle Total Per Bottle

Make Buy


Make or Buy andMake or Buy andthe Use of Facilitiesthe Use of Facilities

Suppose Nantucket can use the releasedfacilities in other manufacturing activities

to produce a contribution to profits of$55,000, or can rent them out for $35,000.

Suppose Nantucket can use the releasedfacilities 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?What are the alternatives?


Make or Buy andMake or Buy andthe Use of Facilitiesthe Use of Facilities

Rent revenue $ — $ — $ 35 $ —

Contribution from

other products — — — 55

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

Net relevant costs $(170) $(180) $(145) $(125)

Rent revenue $ — $ — $ 35 $ —

Contribution from

other products — — — 55

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

Net relevant costs $(170) $(180) $(145) $(125)

Make

Buy andleave

facilitiesidle

Buy andrent outfacilities

Buy and usefacilitiesfor otherproducts(‘000)


Joint Product CostsJoint Product Costs

Joint products have relativelysignificant sales values.

Joint products have relativelysignificant sales values.

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

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

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

become individually identifiable.

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

become individually identifiable.


Joint ProductsJoint Products

Joint costsJoint costs

Split-off pointSplit-off point Product AProduct A

Product BProduct B



Separable costs are any costsbeyond the split-off point.

Separable costs are any costsbeyond the split-off point.

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

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



Suppose Dow Chemical Company produces2 chemical products, X and Y, as

a result of a particular joint process.

Suppose Dow Chemical Company produces2 chemical products, X and Y, as

a result of a particular joint process.

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

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

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



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

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

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

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

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

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

Split-off point


Illustration of Illustration of Sell or Process FurtherSell or Process Further

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

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

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

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

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


Joint ProductsJoint ProductsRevenue Revenue

X

1,000,000 litres of X @ RM0.09 = RM90,000

Joint processing cost RM100,000 Y

500,000 litres of Y @ RM0.06 = RM30,000 YA

500,000 litres of YA @ RM0.16 = RM80,000 Processing costs: 500,000 litres of YA @ RM0.08 RM40,000


Illustration of Illustration of Sell or Process FurtherSell or Process Further

Revenue - Y $30,000 $80,000 $50,000Separable costs beyond split-off @ $.08 – (40,000) (40,000)Revenue – X 90,000 90,000 -Joint processing (100,000) (100,000) -___Income effects 20,000 $30,000 $10,000

Revenue - Y $30,000 $80,000 $50,000Separable costs beyond split-off @ $.08 – (40,000) (40,000)Revenue – X 90,000 90,000 -Joint processing (100,000) (100,000) -___Income effects 20,000 $30,000 $10,000

Sell atSplit-off

as Y

ProcessFurther andSell as YA Difference


Irrelevance of Past CostsIrrelevance of Past Costs

The ability to recognize and therebyignore irrelevant costs is important

to decision makers.

The ability to recognize and therebyignore irrelevant costs is important

to decision makers.


Example of Irrelevance ofExample of Irrelevance ofObsolete InventoryObsolete Inventory

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

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

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



General Dynamics can...General Dynamics can...

remachine the parts for $30,000and then sell them for $50,000, or

remachine the parts for $30,000and then sell them for $50,000, or

scrap them for $5,000.scrap them for $5,000.

Which should it do?Which should it do?



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.

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.

DifferenceDifferenceRemachineRemachine ScrapScrap


Book Value of Old Book Value of Old EquipmentEquipment

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

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

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



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.



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 6,000Book valueBook value $ 4,000$ 4,000

Original costOriginal cost $10,000$10,000Accumulated depreciation (6 × $1,000)Accumulated depreciation (6 × $1,000) 6,000 6,000Book valueBook value $ 4,000$ 4,000


Keep or Replace an Old Keep or Replace an Old Machine ?Machine ?

Original cost $10,000 $8,000Useful life in years 10 4Current age in years 6 0Useful life remaining in years 4 4Accumulated depreciation $ 6,000 0Book value $ 4,000 N/ADisposal value (in cash) now $ 2,500 N/ADisposal value in 4 years 0 0Annual cash operating costs $ 5,000 $3,000

Original cost $10,000 $8,000Useful life in years 10 4Current age in years 6 0Useful life remaining in years 4 4Accumulated depreciation $ 6,000 0Book value $ 4,000 N/ADisposal value (in cash) now $ 2,500 N/ADisposal value in 4 years 0 0Annual cash operating costs $ 5,000 $3,000

OldOldMachineMachine

ReplacementReplacementMachineMachine


Cost ComparisonCost Comparison

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

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

DifferenceDifferenceKeepKeep ReplaceReplace

4 Years Together4 Years Together


Make or Buy: Another Make or Buy: Another Example Example

Sunshine Fruit Company sells premium-quality oranges Sunshine Fruit Company sells premium-quality oranges by mail order. Protecting the fruit during shipping is by mail order. Protecting the fruit during shipping is important, so the company has designed & produces important, so the company has designed & produces shipping boxes. The annual cost to make 80,000 shipping boxes. The annual cost to make 80,000 boxes is:boxes is:

MaterialsMaterials 120,000120,000

LabourLabour 20,00020,000

Indirect manufacturing costs – Indirect manufacturing costs – variablevariable

16,00016,000

Indirect manufacturing costs – fixedIndirect manufacturing costs – fixed 60,00060,000

TotalTotal 216,000216,000

Cost per box = RM2.70.Cost per box = RM2.70.



Suppose an external supplier submits a bid to Suppose an external supplier submits a bid to supply Sunshine with boxes for RM2.40 per box. supply Sunshine with boxes for RM2.40 per box. Sunshine must give the supplier the box design Sunshine must give the supplier the box design specifications, and the boxes will be made specifications, and the boxes will be made according to those specs.according to those specs.

QuestionQuestion

How much, if any, would Sunshine save by buying How much, if any, would Sunshine save by buying the boxes from the external supplier?the boxes from the external supplier?



The key to this question is what will happen to the fixed The key to this question is what will happen to the fixed overhead costs if production of the boxes is discontinued. overhead costs if production of the boxes is discontinued. Assume that all RM60,000 of fixed costs will continue. Assume that all RM60,000 of fixed costs will continue. Then, Sunshine will lose RM36,000 by purchasing the boxes Then, Sunshine will lose RM36,000 by purchasing the boxes from the supplier:from the supplier:

Payment to supplierPayment to supplier 80,000 x $2.40 80,000 x $2.40 $192,000$192,000Costs saved, variable costsCosts saved, variable costs 156,000 156,000Additional costsAdditional costs $ 36,000$ 36,000



QuestionQuestion

What What subjective factorssubjective factors should affect Sunshine‘s should affect Sunshine‘s decision whether to make or buy the boxes?decision whether to make or buy the boxes?

Some subjective factors are:Some subjective factors are: Might the supplier raise prices if Sunshine closed down its Might the supplier raise prices if Sunshine closed down its box-making facility?box-making facility? Will sub-contracting the box production affect the quality of Will sub-contracting the box production affect the quality of the boxes?the boxes? Is a timely supply of boxes assured, even if the number Is a timely supply of boxes assured, even if the number needed changes?needed changes? Does Sunshine State sacrifice proprietary information when Does Sunshine State sacrifice proprietary information when disclosing the box specifications to the supplier?disclosing the box specifications to the supplier?


Make or Buy: Another Make or Buy: Another

Question

Suppose all the fixed costs represent depreciation on equipment that was purchased for RM600,000 and is just about at the end of its 10-year life.

New replacement equipment will cost RM1 million and is also expected to last 10 years.

In this case, how much, if any, would Sunshine save by buying the boxes from the supplier?



In this case the fixed costs are relevant. However, it is In this case the fixed costs are relevant. However, it is not the depreciation on the old equipment that is not the depreciation on the old equipment that is relevant. It is the cost of the new equipment. Annual relevant. It is the cost of the new equipment. Annual cost savings by not producing the boxes now will be:cost savings by not producing the boxes now will be:

Variable costsVariable costs $156,000$156,000Investment avoided (annualized)Investment avoided (annualized) 100,000100,000Total savedTotal saved $256,000$256,000

The payment to supplier is $256,000-$192,000 = The payment to supplier is $256,000-$192,000 = $64,000 less than the savings, so Sunshine would be $64,000 less than the savings, so Sunshine would be $64,000 better off subcontracting the production of the $64,000 better off subcontracting the production of the boxes.boxes.


Joint Products: Another Joint Products: Another ExampleExample

The Mussina Chemical Company produced 3 joint The Mussina Chemical Company produced 3 joint products at a joint cost of RM117,000. These products products at a joint cost of RM117,000. These products were processed further & sold as follows:were processed further & sold as follows:

Chemical Chemical productproduct

SalesSales Additional Additional processing costsprocessing costs

AA 230,000230,000 190,000190,000

BB 330,000330,000 300,000300,000

CC 175,000175,000 100,000100,000



The company has had an opportunity to sell at The company has had an opportunity to sell at split-off directly to other processors. If that split-off directly to other processors. If that alternative had been selected, sales would have alternative had been selected, sales would have been A: RM54,000, B: RM28,000, C: RM54,000.been A: RM54,000, B: RM28,000, C: RM54,000.

The company expects to operate at the same level The company expects to operate at the same level of production and sales in the forthcoming year.of production and sales in the forthcoming year.

Consider all the available information, and assume Consider all the available information, and assume that all cost incurred after split-off are variable.that all cost incurred after split-off are variable.



QuestionQuestion

1. Could the company increase operating 1. Could the company increase operating income by altering its processing decisions? income by altering its processing decisions?

2. If so, what would be the expected overall 2. If so, what would be the expected overall operating income?operating income?

3. Which products should be processed 3. Which products should be processed further and which should be sold at split-off?further and which should be sold at split-off?



AA BB CC TotalTotal

Sell at split-Sell at split-off:off:

54,00054,000 28,00028,000 54,00054,000 136,000136,000

Process Process further:further:

-RevenueRevenue 230,000230,000 330,000330,000 175,000175,000 735,000735,000

-Additional Additional processing processing costscosts

(190,000)(190,000) (300,000)(300,000) (100,000)(100,000) (590,000)(590,000)

40,00040,000 30,00030,000 75,00075,000 145,000145,000



AA BB CC TotalTotal

Sell at split-Sell at split-off:off:

54,00054,000 28,00028,000 54,00054,000 136,000136,000

Process Process further:further:

-RevenueRevenue 230,000230,000 330,000330,000 175,000175,000 735,000735,000

-Additional Additional processing processing costscosts

(190,000)(190,000) (300,000)(300,000) (100,000)(100,000) (590,000)(590,000)

40,00040,000 30,00030,000 75,00075,000 145,000145,000

ACTIONACTION Sell @ split-Sell @ split-offoff

Process Process furtherfurther

Process Process furtherfurther



Expected overall operating income:Expected overall operating income:

A: 54,000 + A: 54,000 + B: 30,000 + B: 30,000 + C: 75,000 C: 75,000 – – Joint costs 117,000Joint costs 117,000= = RM42,000RM42,000

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