Professional Documents
Culture Documents
Chap 11
Chap 11
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
Define the decision-making process and identify the
types of cost information relevant for decision making
Fifth: Evaluate
Performance
11-4
Relevant Cost Analysis
A relevant cost is a future cost that differs between
the decision alternatives
Both characteristics must be present for a cost to be relevant
Relevant costs can be variable or fixed, but variable costs are
generally relevant while fixed costs are not
Relevant cost analysis and total cost analysis produce the
same results
11-5
Equipment-Replacement Decision Example
Which
Which costs
costs are
are not
not relevant
relevant to to the
the decision
decision to
to keep
keep an
an old
old
machine
machine or
or replace
replace itit with
with aa new,
new, more
more efficient
efficient one?
one?
•• Original
Original cost
cost ofof old
old machine,
machine, $4,200
$4,200
•• Current
Current book
book value
value of of old
old machine,
machine, $2,100
$2,100
•• Purchase
Purchase price
price ofof aa new
new machine,
machine, $7,000
$7,000
•• New
New machine
machine will
will have
have zero
zero salvage
salvage value
value
•• Repairs
Repairs to
to old
old machine
machine wouldwould be
be $3,500
$3,500 and
and would
would
allow
allow one
one more
more year
year ofof productivity
productivity
•• Power
Power for
for either
either machine
machine is is expected
expected to
to be
be
$2.50/hour
$2.50/hour
•• New
New machine
machine will
will reduce
reduce labor
labor costs
costs by
by $0.50/hour
$0.50/hour
•• Expected
Expected level
level of
of output
output forfor next
next year
year is
is 2,000
2,000 units
units
11-6
Equipment Replacement Decision
(continued)
The
The relevant
relevant costs
costs are....
are....
•• Purchase
Purchase price
price of
of aa new
new machine,
machine, $7,000
$7,000
•• Repairs
Repairs to
to old
old machine
machine would
would be
be $3,500
$3,500 and
and
would
would allow
allow one
one more
more year
year of
of productivity
productivity
•• New
New machine
machine will
will reduce
reduce labor
labor costs
costs by
by
$0.50/hour
$0.50/hour
11-7
Relevant Cost Analysis: Additional
Considerations
Batch-level cost drivers should be considered in
relevant cost analysis
11-10
Relevant Cost Analysis vs.
Strategic Analysis
11-11
Relevant Cost Analysis and Strategic Analysis
in Decision Making
This decision framework can be used to address
common management decisions such as:
TTS,
TTS, Inc.
Inc. normally
normally charges
charges $9.00
$9.00 per
per T-shirt,
T-shirt, but
but
Alpha
Alpha Beta
Beta Gamma
Gamma has has offered
offered to
to pay
pay $6.50
$6.50 for
for
1,000
1,000 T-shirts.
T-shirts. What
What are
are the
the relevant
relevant costs
costs in
in
determining
determining ifif the
the offer
offer should
should bebe accepted?
accepted?
11-13
The Special-Order Decision (continued)
TTS, Inc.
Variable Cost of Production
Total Cost for
Cost Type Unit Costs One Batch of 1,000 Units
Relevant Costs
Unit-level Costs
Unprinted T-shirt $ 3.25 $ 3,250
Ink and other supplies 0.95 950
Operating labor 0.85 850
Total Unit-level Costs $ 5.05 $ 5,050
Batch-level Costs*
Setup $ 130
Inspection 30
Materials handling 40
Total ($200/batch and $.20/unit) $ 0.20 $ 200
Total Relevant Costs $ 5.25 5,250
*That vary with number of batches
11-14
The Special-Order Decision (continued)
The costs that are TTS, Inc.
not relevant total Fixed Costs
$450,000 Setup $ 29,000
Inspection 9,000
Materials handling 7,000
Machine-related 315,000
Other 90,000
$ 450,000
Therefore.....
11-15
The Special-Order Decision (continued)
Analysis of the net contribution looks favorable
Analysis of Contribution from Alpha Beta Gamma Order
Blue
Blue Tone
Tone is is currently
currently manufacturing
manufacturing thethe
mouthpiece
mouthpiece forfor its
its clarinet,
clarinet, but
but has
has the
the option
option to
to buy
buy
this
this item
item from
from aa supplier.
supplier. Fixed
Fixed overhead
overhead
costs
costs will
will not
not change
change whether
whether oror not
not Blue
Blue Tone
Tone
chooses
chooses to to make
make or or to
to buy
buy the
the mouthpiece.
mouthpiece.
11-18
Make-or-Buy Example (continued)
Cost to buy the mouthpiece $ 24.00
Cost to manufacture, per unit
Materials $ 16.00
Labor 4.50
Variable overhead 1.00
Total variable costs 21.50
Fixed overhead 6.00
Total cost to manufacture $ 27.50
Total relevant costs 21.50
Savings from continuing to manufacture $ 2.50
11-20
Lease-or-Buy
Example (continued)
The
The indifference
indifference point,
point, 5,000,000
5,000,000 copies,
copies, is
is lower
lower than
than the
the
expected
expected annual
annual machine
machine usage
usage of of 6,000,000
6,000,000 copies.
copies. So,
So, Quick
Quick
Copy
Copy should
should purchase
purchase the
the machine
machine ifif strategic
strategic factors,
factors, such
such as
as
quality
quality of
of the
the copy,
copy, reliability
reliability of
of the
the machine,
machine, and
and benefits
benefits and
and
features
features of
of the
the service
service contract,
contract, are
are favorable
favorable
11-22
Lease-or-Buy Example (continued)
$140,000
Q = 5,000,000
TTS
TTS has
has suffered
suffered anan equipment
equipment malfunction
malfunction causing
causing
400
400 T-shirts
T-shirts not
not to
to be
be acceptable.
acceptable. The
The shirts
shirts can
can be
be
sold
sold as-is
as-is for
for $4.50
$4.50 each
each or
or run
run through
through the
the printing
printing
process
process again.
again. The
The cost
cost of
of running
running the
the T-shirts
T-shirts through
through
the
the printer
printer aa second
second time
time is
is variable
variable cost
cost of
of $1.80
$1.80 per
per
shirt
shirt and
and the
the cost
cost of
of one
one setup.
setup.
11-24
Sell-or-Process Further Example (continued)
Analysis of Reprinting 400 Defective T-Shirts
Reprint Sell As Is
Revenue (400 @ $9.00) $ 3,600
(400 @$4.50) $ 1,800
Relevant costs: (@$1.80 variable + setup)
Supplies and ink ($0.95) 380
Labor ($0.85) 340
Setup, inspection, handling 200
Total relevant costs 920
Contribution margin $ 2,680 $ 1,800
An example follows:
Windbreakers, Inc. manufactures three jackets.
Management is concerned about the low profitability of the
“Gale” jacket and is thinking about dropping the product. If
the jacket is dropped, there will be no change in total fixed
costs for the coming year.
11-26
Profitability Analysis (continued)
Profitability Analysis: Gale Deleted
Calm Windy Total
Units sold last year 25,000 18,750
Sales revenue $ 750,000 $ 600,000 $ 1,350,000
Variable costs (600,000) (450,000) (1,050,000)
Contribution margin 150,000 150,000 300,000
Nonrelevant fixed costs 168,000
Net income without Gale $ 132,000
11-29
Short-Term Product Mix Decision
How to make best use out of existing resources? That
is, how to choose the best short-term product mix?
Continuing with the Windbreaker’s Inc. example
assume one production constraint:
36,000 –
Units of
Production constraint for
Sales sewing machine. All
for Gale possible sales mixes are
represented on this line.
24,000 –
Units of Sales
Slope = -36,000 ÷ 24,000 = -3/2
for Windy
Intercept = 36,000
11-32
Short-term Product-Mix Decision:
One Production Constraint
Units of Gale = 36,000 - 3/2 x Units of Windy
Windy Gale
Contribution margin per unit $ 8 $ 4
Inspection and packing time per jacket 15 min. 5 min.
Number of jackets produced per hour 4 12
Contribution margin per machine hour $ 32 $ 48
Maximum production for each product
(5,600 @ 4) 22,400
(5,600 @ 12) 67,200
11-35
Short-term Product-Mix Decision:
Two Production Constraints
67,200 –
Production constraint for Inspection and Packaging
Units of
22,400
24,000
Sales for
Windy
Corner Point Analysis
11-36
Behavioral and Implementation Issues
Managers must be sure to keep the firm’s strategic
objectives in the forefront in any decision situation to
avoid focusing solely on short-term gains
Predatory pricing occurs when a company has set prices
below average variable cost with a plan to raise prices
later to recover losses from these lower prices
Courts have found in favor of the defendants time after
time in cases involving predatory pricing
U.S. congressional leaders are considering revising the
laws related to predatory pricing to promote competition
in previously uncompetitive industries
11-37
Behavioral and Implementation
Issues (continued)
Management’s goal should be to maximize contribution
margin while minimizing fixed costs
Relevant cost analysis focuses on variable costs, appearing to
ignore fixed costs
If upper-level management focuses too heavily on variable
costs, lower-level management may feel pressure to replace
variable costs with fixed costs at the firm’s expense
Managers must be careful not to include irrelevant,
including sunk, costs in their decision making
When fixed costs are shown as cost per unit, many managers
tend to improperly classify them as relevant
11-38
Chapter Summary
11-39
Chapter Summary (continued)
11-40
Chapter Summary (continued)
• Relevant cost analysis changes significantly with two or
more products and limited resources
– Under conditions of one or more production constraints,
the goal is to find the most profitable sales mix
– For decision-making purposes, product profitability must
be expressed in terms of contribution margin per unit of
the scare resource
• Managers must be careful to encourage maximization of
contribution margin and reduction of fixed costs
• Irrelevant, including sunk, costs must not be included
in relevant cost analysis
11-41