Chapter 4: Relevant Costs and Benefits for Decision- Making

[Pages:30]Chapter 4: Relevant Costs and Benefits for Decision-

Making

Agenda

Sunk/Opportunity Costs Decision Relevance Differential Analysis

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It's all relevant ...

Sunk Costs ? outlays of resources or effort from past periods. These costs should be ignored.

Opportunity Costs ? revenues (or profits) foregone by choosing an alternate course of action. For example, the opportunity cost of you being here is the salary you could be making if you remained in the workforce.

Remember that we use managerial accounting for two major purposes:

Decision-making Control and evaluation

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With respect to decision relevance:

Fixed Cost Depreciation on equipment already

purchased

President's salary which will not change when deciding between two options

Salary of supervisor who will be retained if one action is taken and fired if the other action is taken

Classification Sunk and irrelevant (not incremental)

Not sunk (but still irrelevant), (not incremental)

Not sunk and not irrelevant (incremental)

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Return to our copy center

example:

The copy center hours are currently from 6am to 8pm. The student union is trying to determine whether they should extend the closing time from 8pm to 12 midnight.

The manager estimates that revenue will increase by $800 per day if he extends hours. But he will have to pay a part-time worker for 4 additional hours at $20/hour. Additional paper, toner, and other miscellaneous costs of $500 will be incurred. Finally, utility costs will be increased by $10.

Should the manager extend the hours?

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Should the manager extend the hours?

Incremental revenue per day

$800

Incremental costs per day:

Salary

$ 80

Paper, toner, etc.

500

Utilities

10

590

Incremental profit

$210

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Well, heck ... should we stay open even

later? (How about until 2am?) Additional revenue in the last two

hours is $70. Paper, toner, etc. is $27 for the last

two hours and utility costs are $5. Should the manager stay open until

2am?

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Should the manager stay open until 2 a.m.?

Incremental revenue per day

$70

Incremental costs per day:

Salary

$ 40

Paper, toner, etc.

27

Utilities

5

72

Incremental profit

($ 2)

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Differential Analysis:

Differential analysis is a tool that determines the effect on profitability of possible courses of action to be taken in the future.

Differential analysis allows the decision- maker to rank-order decision alternatives based on incremental effect of profitability.

Pricing changes Production changes Vendor comparisons Cost consumption analyses (i.e., discretionary costs such as marketing,

R&D, etc.) Customer selection Product line selection Special orders

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Differential Analysis Cont.:

Differential analysis allows the decision- maker to rank-order decision alternatives based on incremental effect of profitability.

Acquisitions, mergers, and divestitures Joint ventures Outsourcing decisions Make or buy decisions Bonus/compensation plans Sell or process further

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Caution

Immediate profit effects should be considered in light of effects on pricing, production capacity constraints, duration of contract (product demand and cost structures may change over time), etc.

It's usually not relevant to consider fixed costs in differential analysis unless the decision involves exceeding current capacity levels (then there is a marginal increase in fixed costs that would be relevant).

Likewise, long-term contracts should consider all costs since a firm has to cover its total costs to stay in business in the long-run.

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Additional Processing Decision:

PowerComp has decided to discontinue its Model 250 computer.

It currently has 5,000 partially completed units on hand. To date, the company has spent $800 per unit, or $4,000,000

to bring these computers to their current stage of completion. What kind of cost is the $4,000,000? SUNK Should it be considered for decision-making at this point in

time? NO

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Additional Processing Decision:

The company estimates that an additional $400 per unit will be incurred to complete production.

Because the company has announced the product will be discontinued, prices have fallen.

If the units are completed, they can be sold for only $1,000. How does this price compare to total cost per unit?

$1,000 price < ($800 + $400) total cost Should the company complete production? Or should

they sell them to an assembly company as they are for $500/unit?

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Additional Processing Decision:

Sell in current state

$ 500

Sell in completed state Additional costs to complete Profit

$1,000 (400)

$ 600

What should we do?

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Make or Buy Decision:

Suppose we manufacture refrigerators and compressors are one of our numerous components. Cooper Compressors offers to sell us their compressors at $310 per unit. We currently make our own compressors (50,000 units) and our costs are as follows:

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Costs:

Variable Costs Direct materials ($100 per unit) Direct labor ($120 per unit) Variable overhead ($80 per unit)

Total Variable Costs

Fixed Costs Depreciation of Building Depreciation of Equipment Supervisory Salaries Other

Total Fixed Costs Total Cost Cost per unit

$ 5,000,000 6,000,000 4,000,000

$15,000,000

$ 600,000 800,000 500,000 350,000

$ 2,250,000 $17,250,000

$345

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