Edmonds Managerial Chapter 14

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CHAPTER 5
Relevant Information for Special Decisions
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Learning Objective
To identify the characteristics of relevant
information
LO1
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Relevant Information

• Two primary characteristics distinguish
  relevant from useless information
• Relevant information differs among the
  alternatives under consideration.
• Relevant information is future oriented.

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Sunk Cost
A sunk cost has been incurred in a past
transaction and cannot be changed. It is not
relevant for making current decisions.
Wish I hadnt bought that stock. Cost me 25,000,
and now its worth only 15,000. I really need a
car but dont have the cash!
Just sell the stock and buy the car!
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Sunk Cost
A sunk cost has been incurred in a past
transaction and cannot be changed. It is not
relevant for making current decisions.
Youve already taken the loss. The 25,000 is a
sunk cost. Like I said, sell the stock and buy
the car you need.
I dont want to take the loss!
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Opportunity Costs
An opportunity cost is the sacrifice that is
incurred in order to obtain an alternative
opportunity.
The opportunity cost of owning the stock is
15,000. That is the amount you could receive if
you decide to sell.
I think I am beginning to see what you mean.
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Relevance Is an Independent Concept
Management at Better Bakery Products is debating
whether to add a new product, either cakes or
pies, to the companys product line. Projected
costs are shown
Under either alternative, a new production
supervisor must be hired at a cost of 25,000 per
year. Cakes are distributed under a nationally
advertised label. Pies are marketed under the
companys own name and will require new
advertising.
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Relevance Is an Independent Concept
Which costs are relevant?
Material costs are relevant because they differ.
Fifty cents can be avoided by choosing cakes
instead of pies. Labor costs and the supervisors
salary are not relevant because they do not
differ. The advertising costs can be avoided if
the company elects to make cakes. Whether a cost
is fixed or variable has no bearing on its
relevance.
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Relevance is Context-Sensitive
A particular cost that is relevant in one context
may be irrelevant in another.
A department store sells mens, womens, and
childrens clothing. The store managers salary
could not be eliminated if the store eliminated
the line of childrens clothing. Is the store
managers salary relevant to the decision to stop
selling childrens clothing?
No, the store managers salary will be the same
if childrens clothing is no longer sold.
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Relevance is Context-Sensitive
A particular cost that is relevant in one context
may be irrelevant in another.
Would the store managers salary be a relevant
cost, if the company was thinking about closing
the store completely?
Yes, it is a relevant cost. If the store remains
open, the company will incur the managers
salary. If the store is closed, the cost will be
eliminated.
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Relationship BetweenRelevance and Accuracy
Information need not be exact to be relevant.
You may be considering the purchase of a laptop
computer. You may decide to delay your decision
because you think the price will decrease. You
are not sure of the amount of the price drop, but
you do believe part of the cost can be avoided by
waiting.
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Quantitative Versus Qualitative Characteristics
Relevant information can have both quantitative
and qualitative characteristics.
A quantitative focus considers the cost,
increase in profits, or other numerical aspects
of the decision.
A qualitative focus considers non-quantitative
aspects such as the impact on people and
attractiveness of the products.
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Differential Revenue and Avoidable Cost
Relevant revenues must (1) be future oriented and
(2) differ for the alternatives under
consideration. Since relevant revenues differ
between the alternatives, they are sometimes
called differential revenues.
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Differential Revenue and Avoidable Cost
Avoidable costs are the costs managers can
eliminate by making specific choices.
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Learning Objective
To distinguish between unit-level, batch-level,
product level, and facility-level costs and
understand how these costs affect decision making.
LO2
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Relevant (Avoidable) Costs
Unit-levelCosts
Batch-levelCosts
Product-levelCosts
Facility-levelCosts
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?Check Yourself
Aqua, Inc., makes statues for use in fountains.
On January 1, 2007, the company paid 13,500 for
a mold to make a particular type of statue. The
mold had an expected life of four years and a
salvage value of 1,500. On January 1, 2009, the
mold had a market value of 3,000, and a salvage
value of 1,200. The expected useful life did not
change. What is the relevant cost of using the
mold during 2009?
(3,000 1,200) 2 years 900
Of course, Aqua could avoid the cost by selling
the mold for its market value of 3,000.
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Learning Objective
To make appropriatespecial orderdecisions.
LO3
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Relevant Information andSpecial Decisions
Occasionally, a company receives an offer to sell
its product at a price significantly below its
normal selling price. The company must make a
special order decision to accept or reject the
offer.
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Here is budgeted cost information for Premier, a
company that produces printers. The company has
enough capacity to produce additional printers,
but is planning to produce to meet current demand.
Cost per unit - 658,500 2000 329.25
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Special Order Decision
A foreign customer offers to purchase 200
printers at 250 per printer. This price is well
below the unit cost of 329.25. Should the
company accept this one time order?
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Special Order Decision
Opportunity Costs
Premier has excess productive capacity. Suppose
Premier has the opportunity to lease its excess
capacity (unused building and equipment) for
15,000. Should Premier accept the special offer
given this new information?
If the order is rejected, profitability will
decrease by 3,200.
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Special Order Decision
Relevance and the Decision Context
If Premier can increase income by selling its
printers for 250, can the company reduce its
normal selling price to 250?
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Special Order Decision
Qualitative Characteristics
Should a company ever reject a special order if
the relevant revenues exceed the relevant costs?
What will happen if Premiers regular customers
learn that the company sold printers to another
buyer for 250 per unit?
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Learning Objective
To make appropriateoutsourcing decisions.
LO4
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Outsourcing Decisions
Companies can sometimes purchase products needed
in the manufacturing process for less than it
would cost to make them. Buying goods and
services from other companies rather than
producing them internally is commonly called
outsourcing.
That test was so easy. How did you score so low?
I outsourced my homework!!
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Outsourcing Decisions
Lets return to our Premier example. Recall that
the unit cost per printer was 329.25. A supplier
offers to sell an unlimited number of printers to
Premier for 240 each. Should Premier accept this
outsourcing offer?
Step 1Determine the production costs Premier can
avoid if itelects to outsource printer
production.
Cost per unit 459,300 2,000 229.65
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Outsourcing Decisions
Step 2Compare the avoidable production costs
with the cost ofbuying the product and select
the lower-cost option.
Premier should reject the outsourcing offer.
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Outsourcing Decisions
Opportunity Costs
If Premier purchases the printers, it could use
its manufacturing space for storing finished
goods inventory. Premier is currently renting
warehouse space at the cost of 40,000. Should
Premier continue to manufacture the printers?
Cost per unit 499,300 2,000 249.65
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Growth and the Level of Production
The decision to outsource would change if
expected production increases from 2,000 to 3,000
units. Some avoidable costs are fixed relative to
production, so cost per unit decreases as volume
increases. If Premier outsources the 3,000
printers it will save 40,000 currently being
spent on warehouse space.
Management should reject the offer, but if
growthis expected in the future it must be
factored intomanagements decision.
Cost per unit 690,300 3,000 230.10
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Qualitative Features
A company that uses vertical integration controls
the full range of activities from acquiring raw
materials to distributing goods and services. An
oil company, like ExxonMobil, is a good example
of vertical integration.
Outsourcing reduces the level of vertical
integration,passing some of a companys control
over itsproduction to outside suppliers.
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Learning Objective
To make appropriatesegment eliminationdecisions.
LO5
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Segment Elimination Decisions
Businesses are frequently organized into
operating units known as segments. Segment
reports can be prepared for products, services,
departments, branches, centers, offices, or
divisions. These reports normally show segment
revenues and costs. Lets look at a segment
report for Premier Office Products that has
divided its operations into three segments (1)
copiers, (2) computers, and (3) printers.
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Should management eliminate the copier segment?
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Segment Elimination Decisions

• A three part decision
• Determine the amount of relevant revenue that
  pertains to eliminating the segment.
• Determine the amount of cost that can be avoided
  if the segment is eliminated.
• If the relevant revenue is less than the
  avoidable cost, eliminate the segment. If not,
  continue to operate it.

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Segment Elimination Decisions
Step 1If Premier eliminates the copier segment,
it will lose the 550,000 of revenue currently
earned. If the segment continues, the revenue
will be earned. Since the revenue differs between
the alternatives, it is relevant.
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Segment Elimination Decisions
Step 2If Premier eliminates copiers, it will
avoid the following costs
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Segment Elimination Decisions
Step 3If Premier eliminates copiers, its
profits will decrease
The corporate-level facility-sustaining costs
will not be eliminated, but will be allocated to
the remaining segments.
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Assuming we eliminate the copier segment and
allocate the corporate-level costs to the
remaining two divisions equally, the companys
income statement will look like this.
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Qualitative Considerations

• Employee lives will be disrupted.
• Sales of different product lines are frequently
  interdependent.
• What will happen to the space freed by the
  eliminated segment?
• Volume changes can affect elimination decisions.

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Relationships Between Avoidable Costs and
Business Activity

• Special order decisions affect unit-level and
  possibly batch-level costs.
• Outsourcing can avoid many product-level as well
  as unit- and batch-level costs.
• Segment elimination can avoid some of the
  facility-level costs.

The more complex the decision level, the more
opportunities there are to avoid costs.
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Learning Objective
To make appropriateasset replacementdecisions.
LO6
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Equipment Replacement Decisions
The equipment replacement decision should be
based on profitability rather than physical
deterioration. Consider the following
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Equipment Replacement Decisions

• The original cost, current book value,
  accumulated depreciation, and annual depreciation
  expense are measures of cost of the old machine
  relating to prior periods. They are irrelevant
  because they are sunk costs.
• The 14,000 market value of the old machine is an
  opportunity cost and is relevant to the
  replacement decision.
• The salvage value of the old machine reduces the
  opportunity cost. The opportunity cost of using
  the old machine for five more years is 12,000
  (14,000 2,000).
• The 45,000 operating expenses of using the old
  machine can be avoided if it is replaced, It is a
  relevant cost.

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Equipment Replacement Decisions

• The cost of the new machine can be avoided by
  keeping the old machine. It is a relevant cost.
• The relevant cost of purchasing the new machine
  is 25,000 (29,000 4,000).
• The 22,500 of operating expenses can be avoided
  by keeping the old machine. The operating
  expenses are relevant costs.

Lets summarize the relevant costs for the two
machines.
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Equipment Replacement Decisions
Our analysis shows that Premier should acquire
the new machine. Over a five-year period the
company will save a total of 9,500(57,000
47,500).
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End of Chapter 5