RELEVANT INFORMATION AND DECISION MAKING: PRODUCTION DECISIONS

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CHAPTER 6

• RELEVANT INFORMATION AND DECISION MAKING
  PRODUCTION DECISIONS

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CHAPTER 6Learning Objectives

• Use opportunity cost to analyze the income
  effects of a given alternative.
• Decide whether to make or buy certain parts or
  products.

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CHAPTER 6Learning Objectives

• Decide whether a joint product should be
  processed beyond the split-off point.
• Identify irrelevant information in disposal of
  obsolete inventory and equipment replacement
  decisions.

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CHAPTER 6Learning Objectives

• Explain how unit costs can be misleading.
• Discuss how performance measures can affect
  decision making.

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CHAPTER 6Learning Objectives

• Understand the relationship between accounting
  information and decisions in the production stage
  of the value chain.

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Opportunity Cost

• An opportunity cost is the maximum available
  contribution to profit foregone (or passed up) by
  using limited resources for a particular purpose.

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Outlay Cost

• An outlay cost requires a cash disbursement.

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Differential Cost

• Differential cost and incremental cost are
  defined as the difference in total cost between
  two alternatives.

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Make-or-Buy Decisions

• The basic make-or-buy question is whether a
  company should make its own parts to be used in
  its products or buy them from vendors.

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Make-or-Buy Decisions

• Qualitative Factors
• Control Quality
• Protect Long-Term Relationships with Suppliers

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Make-or-Buy Decisions

• Quantitative Factors
• Idle Facilities or Capacity

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Make-or-Buy Example

• General Electric Company
• Cost of Making Part No. 900
• Total Cost for Cost
• 20,000 Units per Unit
• Direct material 20,000 1
• Direct labour 80,000 4
• Variable factory overhead 40,000 2
• Fixed factory overhead 80,000 4
• Total costs 220,000 11

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Make-or-Buy Example

• Another manufacturer offers to sell General
  Electric (GE) the same part for 10.
• Should GE make or buy the part?

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Make-or-Buy Example

• Although the 11 unit cost shown seemingly
  indicates that the company should buy, the answer
  is rarely so obvious.
• The essential question is the difference in
  expected future costs between the alternatives.

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Make-or-Buy Example

• If the 4 fixed overhead per unit consists of
  costs that will continue regardless of the
  decision, the entire 4 becomes irrelevant.

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Make-or-Buy Example

• If 20,000 of the fixed costs will be eliminated
  if the parts are bought instead of made, the
  fixed costs that may be avoided in the future are
  relevant.

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Make-or-Buy Example

• The key to make-or-buy decisions is identifying
  the additional costs for making (or the costs
  avoided by buying) a part or subcomponent.

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Make-or-Buy Example

• Make Buy
• Total Per Unit Total Per Unit
• Purchase cost 200,000 10
• Direct material 20,000
  1
• Direct labor 80,000 4
• Variable factory overhead 40,000 2
• Fixed factory overhead
• that can be avoided
• by not making 20,000 1
  - -
• Total relevant costs 160,000 8
  200,000 10
• Difference in favor
• of making 40,000 2

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Joint Products

• Joint products is defined as two or more
  manufactured products that (1) have relatively
  significant sales values and
• (2) are not separately identifiable as
  individual products until their split-off point.

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Split-Off Point

• The split-off point is that juncture of
  manufacturing where the joint products become
  individually identifiable.

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Separable Costs

• Any costs beyond the split-off point are called
  separable costs.

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Joint Costs

• The costs of manufacturing joint products before
  the split-off point are called joint costs.

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Illustration of Joint Costs

• Suppose Dow Chemical Company produces two
  chemical products, X and Y, as a result of a
  particular joint process.
• The joint processing cost is 100,000.
• Both products are sold to the petroleum industry
  to be used as ingredients of gasoline.

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Illustration of Joint Costs

• 1,000,000 Liters of X
• Joint-Processing _at_ Selling Price of .09
  90,000
• Cost, 100,000
• 500,000 Liters of Y
• Split-Off _at_ Selling Price of .06
  30,000
• Point
• Total Sales Value
• at Split-Off 120,000

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Sell or Process Further

• Managers frequently face decisions of whether to
  sell joint products at split-off or to process
  some or all products further.

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Illustration of Sell or Process Further

• Suppose the 500,000 liters of Y can be processed
  further and sold to the plastics industry as
  product YA.
• The additional processing cost would be .08 per
  liter for manufacturing and distribution, a total
  of 40,000.
• The net sales price of YA would be .16 per
  liter, a total of 80,000.

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Illustration of Sell or Process Further

• Sell at Process
• Split-Off Further
• as Y and Sell as YA
  Difference
• Revenue 30,000 80,000 50,000
• Separable costs
• beyond
• split-off _at_ .08 --
  40,000 40,000
• Income effects 30,000 40,000 10,000

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Irrelevance of Past Costs

• The ability to recognize and thereby ignore
  irrelevant costs is sometimes just as important
  to decision makers as identifying relevant costs.

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Irrelevance of Past Costs

• How do we know that past costs, although
  sometimes predictors, are irrelevant in decision
  making?

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Irrelevance of Past Costs

• Two examples of past costs that we can consider,
  to see why they are irrelevant to decisions, are
• the cost of obsolete inventory and
• the book value of old equipment.

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Example of Irrelevance ofObsolete Inventory

• Suppose General Dynamics has 100 obsolete
  aircraft parts in its inventory. The original
  manufacturing cost of these parts was 100,000.

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Example of Irrelevance ofObsolete Inventory

• General Dynamics can
• (1) remachine the parts for 30,000 and then
  sell them for 50,000 or
• (2) scrap them for 5,000.
• Which should it do?

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Example of Irrelevance ofObsolete Inventory

• Remachine Scrap Difference
• Expected future revenue 50,000 5,000
  45,000
• Expected future costs 30,000 --
  30,000
• Relevant excess of
• revenue over costs 20,000 5,000
  15,000
• Accumulated historical
• inventory cost 100,000 100,000
  -- -
• Net overall loss on project (80,000)
  (95,000) 15,000

Irrelevant because it is unaffected by the
decision
.
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Irrelevance of Book Valueof Old Equipment

• Like obsolete parts, the book value of equipment
  is not a relevant consideration in deciding
  whether to replace the equipment.
• Why?
• Because it is a past, not a future cost.

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Depreciation

• Depreciation is the periodic allocation of the
  cost of equipment which is spread over (or
  charged to) the future periods in which the
  equipment is expected to be used.

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Book Value

• The equipments book value (or net book value)
  is the original cost less accumulated
  depreciation, which is the sum of all
  depreciation charged to past periods.

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Example Book Value Computation

• Suppose a 10,000 machine with a 10-year life
  has depreciation of 1,000 per year. At the end
  of six years
• Original cost 10,000
• Accumulated depreciation
• (6 x 1,000) 6,000
• Book value 4,000

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Keep or Replace an Old Machine?

• Consider the following data for a decision
  whether to replace an old machine

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Data for Decision

• Old Replacement
• Machine Machine
• Original cost 10,000 8,000
• Useful life in years 10 4
• Current age in years 6 0
• Useful life remaining in years 4 4
• Accumulated depreciation 6,000 0
• Book value 4,000 Not acquired
  yet
• Disposal value (in cash) now 2,500
  Not acquired yet
• Disposal value in 4 years 0 0
• Annual cash operating costs
• (maintenance, power, repairs,
• coolants, etc.) 5,000
  3,000

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Keep or Replace an Old Machine?

• Before proceeding, consider some important
  concepts.
• The most widely misunderstood facet of
  replacement decision making is the role of the
  book value of the old equipment in the decision.

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Sunk Cost

• The book value, in this context, is sometimes
  called a sunk cost.
• A sunk cost is a cost that has already been
  incurred and, therefore, is irrelevant to the
  decision-making process.

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Relevance of Equipment Data

• In deciding whether to replace or keep existing
  equipment, we must consider the relevance of four
  commonly encountered items
• Book value of old equipment,
• Disposal value of old equipment,
• Gain or loss on disposal, and
• Cost of new equipment.

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Book Value of Old Equipment

• The book value of old equipment is irrelevant
  because it is a past (historical) cost.
  Therefore, depreciation on old equipment is
  irrelevant.

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Disposal Value of Old Equipment

• The disposal value of old equipment is relevant
  (ordinarily) because it is an expected future
  inflow that usually differs among alternatives.

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Gain or Loss on Disposal

• This is the difference between book value and
  disposal value. It is therefore a meaningless
  combination of irrelevant (book value) and
  relevant items (disposal value). It is best to
  think of each separately.

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Cost of New Equipment

• The cost of the new equipment is relevant
  because it is an expected future outflow that
  will differ among alternatives. Therefore
  depreciation on new equipment is relevant.

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Comparative Analysis of the Two Alternatives

• Four Years Together
• Keep Replace Difference
• Cash operating costs 20,000 12,000
  8,000
• Old equipment (book value)
• Depreciation or 4,000 -- --
• Lump-sum write-off 4,000 --
• Disposal value -- -2,500
  2,500
• New machine
• Acquisition cost --
  8,000 -8,000
• Total costs 24,000 21,500
  2,500

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Beware of Unit Costs

• There are two major ways to go wrong when using
  unit costs in decision making
• (1) the inclusion of irrelevant costs, and
• (2) comparisons of unit costs not computed on
  the same volume basis.

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Unit Costs forMake-or-Buy Decision

• In the General Electric make-or-buy example, the
  inclusion of irrelevant costs, such as the 3
  allocation of unavoidable fixed costs, would
  result in a unit cost of 11 instead of the
  relevant unit cost of 8.

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Unit Costs forVolume Basis Decision

• To demonstrate how comparisons of unit costs not
  computed on the same volume basis can be
  misleading, review the following example

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Example Volume Basis Decision

• Assume that a new 100,000 machine with a
  five-year life can produce 100,000 units a year
  at a variable cost of 1 per unit, as opposed to
  a variable cost per unit of 1.50 with an old
  machine.
• Is the new machine a worthwhile acquisition?

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Example Volume Basis Decision

• Old New
• Machine Machine
• Units 100,000 100,000
• Variable cost per unit 1.50 1.00
• Variable costs 150,000 100,000
• Straight-line depreciation -- -
  20,000
• Total relevant costs 150,000 120,000
• Unit relevant costs 1.50
  1.20

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Example Volume Basis Decision

• It appears that the new machine will reduce cost
  by .30 per unit.
• However, if the expected volume is only 30,000
  units per year, the unit costs change in favour
  of the old machine.

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Example Volume Basis Decision

• Old New
• Machine Machine
• Units 30,000 30,000
• Variable cost per unit 1.50 1.00
• Variable costs 45,000 30,000
• Straight-line depreciation -- -
  20,000
• Total relevant costs 45,000 50,000
• Unit relevant costs 1.50 1.6667

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Performance Measures Can Affect Decision Making

• To motivate managers to make the right choices,
  the method used to evaluate performance should be
  consistent with the decision model.

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Example Effect onDecision Making

• Consider the replacement decision, discussed
  earlier, where replacing the machine had a 2,500
  advantage over keeping it.

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Example Effect onDecision Making

• Because performance is often measured by
  accounting income, consider the accounting income
  in the first year after replacement compared with
  that in years 2, 3, and 4.

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Example Effect onDecision Making

• Year 1 Years 2, 3, and 4
• Keep Replace Keep Replace
• Cash operating
• costs 5,000 3,000 5,000
  3,000
• Depreciation 1,000 2,000 1,000
  2,000
• Loss on disposal
• (4,000 - 2,500) -- - 1,500
  -- - -- -
• Total charges
• against revenue 6,000 6,500 6,000
  5,000

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Example Effect onDecision Making

• If the machine is kept rather than replaced,
  first-year costs will be 500 lower (6,500 -
  6,000), and first-year income will be 500
  higher.

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Example Effect onDecision Making

• Because managers naturally want to make
  decisions that maximize the measure of their
  performance, they may be inclined to keep the
  machine.

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Performance Measures vs. Decision Making

• This is an example of a conflict between the
  analysis for decision making and the method used
  to evaluate performance.

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Production Stage of the Value Chain

• In the production stage of the value chain,
  managers make decisions about product mix,
  production equipment, labour, and all other
  factors that affect the creation of goods and
  services.

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Production Stage of the Value Chain

• Managers need timely and relevant accounting
  information to make these decisions on an
  objective, quantifiable basis.