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Fourteen: Decision Making: Relevant Costs and Benefits
Fourteen: Decision Making: Relevant Costs and Benefits
Fourteen: Decision Making: Relevant Costs and Benefits
Learning Objective 1
McGraw-Hill/Irwin
Exh. 14-1
Quantitative Analysis
Learning Objective 2
McGraw-Hill/Irwin
6. Make a Decision
Qualitative Considerations
Learning Objective 3
McGraw-Hill/Irwin
Relevant Information
Information is relevant to a decision problem when . . .
It has a bearing on the future, It differs among competing alternatives.
Learning Objective 4
McGraw-Hill/Irwin
Relevant Costs
Worldwide Airways is thinking about replacing a three year old loader with a new, more efficient New loader loader.
List price Annual operating expenses Expected life in years Old loader Original cost Remaining book value Disposal value now Annual variable expenses Remaining life in years $ 15,000 45,000 1 $ 100,000 25,000 5,000 80,000 1
Relevant Costs
De pre ciation of old loade r Write -off of old loade r $ 25,000 $ P roce e ds from s ale of old loade r (5,000) 5,000 If of we the depreciation De pre ciation n ekeep w loade r old loader, we will have 15,000 (15,000) Ope ratin g cos ts 80,000 45,000 35,000 costs of $25,000. If we replace the old loader, Total cos ts we will write-off the $ 105,000 $ 80,000 $ 25,000 $25,000 when sold. There is Ke e p Old Loade r $ 25,000 Re place Old Loade r Diffe re n tial Cos t
Relevant Costs
De pre ciation of old loade r Write -off of old loade r $ 25,000 $ P roce e ds from s ale of old loade r (5,000) 5,000 De pre ciation of n e w loade r 15,000 (15,000) Ope ratin g cos ts 80,000 45,000 35,000 The $5,000 proceeds will only be realized if we Total cos ts $ 105,000 $ 80,000 $ 25,000 replace the old loader. This amount is relevant. Ke e p Old Loade r $ 25,000 Re place Old Loade r Diffe re n tial Cos t
Relevant Costs
De pre ciation of old loade r Write -off of old loade r $ 25,000 $ P roce e ds from s ale of old loade r (5,000) 5,000 De pre ciation of n e w loade r 15,000 (15,000) Ope ratin g cos ts 80,000 45,000 35,000 Total cos ts We will only have depreciation $ 105,000 $on 80,000 $ 25,000 the new loader Ke e p Old Loade r $ 25,000 Re place Old Loade r Diffe re n tial Cos t
Relevant Costs
De pre ciation of old loade r Write -off of old loade r P roce e ds from s ale of old loade r De pre ciation of n e w loade r Ope ratin g cos ts Total cos ts Ke e p Old Loade r $ 25,000 Re place Old Loade r $ 25,000 (5,000) 15,000 45,000 80,000 Diffe re n tial Cos t $ 5,000 (15,000) 35,000 25,000
80,000 $ 105,000
Relevant Costs
Here is an analysis that includes only relevant costs:
Relevant Cost Analysis Savings in variable expenses provided by the new loader $ 35,000 Cost of the new loader (15,000) Disposal value of old loader 5,000 Net effect $ 25,000
Learning Objective 5
McGraw-Hill/Irwin
Worldwide will save about $5,000 in reservation and ticketing costs if the charter is accepted.
Since the charter will contribute to fixed costs and Worldwide has idle capacity, the company should accept the flight.
Relevant costs will usually be the variable costs associated with the special order.
Same as above but opportunity cost of using the firms facilities for the special order are also relevant.
(135,000) 65,000
( 75,000) $ ( 10,000)
$ 60,000
Conclusion
KEEP THE CLUB OPEN!
Contribution margin from general airline operations that will be forgone if club is eliminated . . . . . . . . . . . $ 60,000 Profit/Loss $ 40,000 Monthly profit of KEEPING the club open
0 0
$ 60,000 $ 40,000
$100,000 =======
Worldwide is better off by $100,000 per month by keeping their club open.
Learning Objective 6
McGraw-Hill/Irwin
A joint production process resulting in two or more products. The point in the production process where the joint products are identifiable as separate products is called the split-off point.
Split-off point Cocoa powder sales value $500 for 500 pounds Separable process costing $800
Joint Products
Relative Sales Value Method
Joint Costs $ Sales Value Relative Joint Products at Split-Off Proportion Cocoa Butter $ 750 1,100 Cocoa Powder 500 $ 1,250 Allocation of Joint Costs
Joint Products
Relative Sales Value Method
Joint Costs $ Sales Value Relative Joint Products at Split-Off Proportion Cocoa Butter $ 750 60% 1,100 Cocoa Powder Allocation of Joint Costs
Joint Products
Relative Sales Value Method
Allocation Joint Sales Value Relative of Joint Costs Joint Products at Split-Off Proportion Costs Cocoa Butter $ 750 60% $ 660 $ 1,100 Cocoa Powder
Joint Products
Relative Sales Value Method
Joint Costs $ Sales Value Relative Joint Products at Split-Off Proportion Cocoa Butter $ 750 60% 1,100 Cocoa Powder 500 40% $ 1,250 100% Allocation of Joint Costs $ 660 440 $ 1,100
Joint Products
Cocoa butter is sold at the end of the joint processing. Cocoa powder may be sold now or processed into instant cocoa mix. Further processing costs of $800 will be incurred if the company elects to make instant cocoa mix.
Joint Products
Process Further Sales value of instant cocoa mix Sales value of cocoa powder Incremental revenue Less: separable processing costs Net benefit of further processing $ $ $ 2,000 ( 500) 1,500 (800) 700
Limited Resources
Martin, Inc. produces two products and selected data is shown below:
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 the lathe per unit Products Highs Webs $ 60 $ 50 36 35 $ 24 $ 15 2,000 2,200 40% 30% 1.00 min. 0.50 min.
Limited Resources
The lathe is the scarce resource because there is excess capacity on other machines. The lathe is being used at 100% of its capacity. The lathe capacity is 2,400 minutes per week.
Limited Resources
Lets calculate the contribution margin per unit of the scarce resource, the lathe.
Products Contribution margin per unit Time required to produce one unit Contribution margin per minute Webs $ 24 1.00 min. $ 24 min. Highs ? ? ?
Limited Resources
Lets calculate the contribution margin per unit of the scarce resource, the lathe.
Products Contribution margin per unit Time required to produce one unit Contribution margin per minute Highs Webs $ 24 $ 15 1.00 min. 0.50 min. $ 24 min. $ 30 min.
Limited Resources
Lets calculate the contribution margin per unit of the scarce resource, the lathe.
Products Contribution margin per unit Time required to produce one unit Contribution margin per minute Highs Webs $ 24 $ 15 1.00 min. 0.50 min. $ 24 min. $ 30 min.
Highs should be emphasized. It is the more valuable use of the scarce resource the lathe, yielding a contribution margin of $30 per minute as opposed to $24 per minute for the Webs.
Limited Resources
Lets calculate the contribution margin per unit of the scarce resource, the lathe.
Products Contribution margin per unit Time required to produce one unit Contribution margin per minute Highs Webs $ 24 $ 15 1.00 min. 0.50 min. $ 24 min. $ 30 min.
If there are no other considerations, the best plan would be to produce to meet current demand for Highs and then use remaining capacity to make Webs.
Limited Resources
Lets see how this plan would work.
Allotting the Scarce Resource The Lathe Weekly demand for Highs 2,200 units Time required per unit x .50 minutes Time required to make Highs 1,100 minutes Total lathe time available Time used to produce Highs Time available for Webs Time required per unit Production of Webs 2,400 minutes 1,100 minutes 1,300 minutes x 1.00 minute 1,300 units
Limited Resources
According to the plan, Martin will produce 2,200 Highs and 1,300 Webs. Martins contribution margin looks like this.
Production and sales (units) Contribution margin per unit Total contribution margin Webs 1,300 $ 24 $ 31,200 Highs 2,200 $ 15 $ 33,000
The total contribution margin for Martin, Inc. is $64,200. Any other combination would result in less contribution.
Theory of Constraints
Binding constraints can limit a companys profitability.
To relax constraints management can . . .
Outsource
Work overtime
Retrain employees
Uncertainty
One common technique for addressing the impact of uncertainty is sensitivity analysis - a way to determine what would happen in a decision analysis if a key prediction or assumption proved to be wrong.
Expected Values
From the last example, recall the the contribution margin for Webs was $24 and $15 for Highs.
Due to uncertainty, assume Martin has the following probable contribution margins for the two products. Webs
Possible value of contribution margin $ 23.00 24.00 25.00 Probability 30% 50% 20% Expected Value $ 6.90 12.00 5.00 $ 23.90
Highs
Possible value of contribution margin $ 14.00 15.00 16.00 Probability 10% 40% 50% Expected Value $ 1.40 6.00 8.00 $ 15.40
Expected Values
From our last example, recall the the contribution margin for Webs was $24 and $15 for Highs. Martin would use the expected value contribution margins in its decision about Due to uncertainty, assume we have the following utilizing its limited resource - two the products. lathe. probable contribution margins for the
Webs
Possible value of contribution margin $ 23.00 24.00 25.00 Probability 30% 50% 20% Expected Value $ 6.90 12.00 5.00 $ 23.90
Highs
Possible value of contribution margin $ 14.00 15.00 16.00 Probability 10% 40% 50% Expected Value $ 1.40 6.00 8.00 $ 15.40
Learning Objective 7
McGraw-Hill/Irwin
Opportunity costs.
End of Chapter 14