Relevant costs and revenues

1
Relevant costs and revenues

• How to identify relevant information in an sea
  of information.
• What product costs are relevant?

2
Kinds of decisions

• Purchase of new equipment
• Special orders
• Dropping/adding a product line
• Dropping/adding a segment
• Make or buy

3
Important information characteristics

• Accurate
• Timely
• Relevant

4
What is relevant information?

• Relevant information differs across decision
  alternatives.

Relevant costs are avoidable (escapable ) costs.
All costs are considered avoidable except
Sunk costs
Costs that dont differacross decision
alternatives
5
Sunk costs

• Basketball tickets
• Tickets to the theater
• Investments in business projects

6
Other cost concepts

• Outlay costs
• Opportunity costs

7
Steps in the decision process

• Define the objective and determine the decision
  criterion
• Identify the potential courses of action
• Assemble all of the costs associated with each
  alternative under consideration
• Eliminate the costs that are sunk
• Eliminate the costs that do not differ across
  alternatives
• Make a decision based on the remaining costs

8
Village Pizza

• Village Pizzas owner bought his current pizza
  oven two years ago for 9000, and it has one more
  year of life remaining. He is using
  straight-line depreciation for the oven. He
  could purchase a new oven for 1900, but it would
  last only one year.
• The owner figures the new oven would save him
  2600 in annual operating costs. Consequently he
  has decided against buying the new oven, since
  doing so would result in a loss of 400 over the
  next year.

9
Village Pizza
How do you suppose the owner came up with400 as
the loss for the next year if the newpizza oven
were purchased? Explain.
10
Village Pizza
What is wrong with the owners analysis?
Provide a correct analysis.
11
Special orders

• Should production be increased to produce the
  special order?
• Yes, if the change in revenues exceeds the change
  in costs.
• Does the company have excess capacity?
• Will the increase in revenues exceed
  out-of-pocket costs?
• Are there strategic issues not captured by the
  financial analysis?

12
Interlaken Chemical Company

• Interlaken Chemical company recently received an
  order for a product it does not normally produce.
  Since the company has excess production
  capacity, management is considering accepting the
  order.
• Production of the special order would require
  8000 kilograms of theolite. Interlaken does not
  use theolite for its regular product, but the
  firm has 8000 kilograms of the chemical on hand
  from the days when it used theolite regularly.
  The book value of the theolite is 2 per
  kilogram. The theolite could be sold to a
  chemical wholesaler for 14,500. Interlaken
  could buy theolite for 2.40 per kilogram.

13
Interlaken Chemical Company

• How would we normally solve this problem?
• Define the decision criterion
• Define the alternatives
• Assemble the costs Product costs
• Eliminate those that are sunk or that do not
  differ across alternatives
• Choose based on the remaining costs

14
Interlaken Chemical Company

• For this problem, were working to assemble the
  costs. What is the relevant cost of the DM
  theolite?

15
Interlaken Chemical Company

• Interlakens special order also requires 1,000
  kilograms of genatope, a solid chemical regularly
  used in the companys products. The current
  stock of genatope is 8,000 kilograms with a book
  value of 8.10 per kilogram.
• If the special order is accepted, the firm will
  be forced to restock genatope earlier than
  expected, at a predicted cost of 8.70 per
  kilogram. Without the special order, the
  purchasing manager predicts that the price will
  be 8.30, when normal restocking takes place.
  Any order of genatope must be in the amount of
  5,000 kilograms.

16
Interlaken Chemical Company

• What is the relevant cost of genatope?

17
Mr. Smiths trip home

• Mr. Smith purchased a round trip airline ticket
  from Durham, NC, to St. Louis, MO. He flew to
  St. Louis on Monday and planned to return on
  Friday. Unknown to him, the corporate jet also
  made the trip to St. Louis this week and was
  scheduled to return on Friday. Mr. Smith thought
  he might as well save the company some money, so
  he cashed in his return ticket and flew home on
  the corporate jet. Did he make the correct
  decision?
• Was the cost of flying the corporate jet from St.
  Louis to Durham relevant?
• Was the cost of the one-way commercial flight
  relevant?
• What would shareholders want Mr. Smith to do?

18
Mr. Smiths trip home

• Mr. Smith is a manager in his company and he is
  evaluated based on his divisions profit. When
  Mr. Smith received his divisional income
  statement for the month, he discovered he had
  been charged more than twice the cost of the
  commercial airline ticket for his trip on the
  corporate jet. Mr. Smith called Accounting to
  question the charge and was told that passengers
  were always allocated a share of the cost of the
  trip. Mr. Smith was charged the same amount as
  the Vice President who ordered the trip. Did he
  make the correct decision?

19
Bonner Company make or buy

• A vendor has offered to supply a component for
  19 (FOB destination) that has previously been
  manufactured internally. Should Bonner make or
  buy?
• Per unit 8000 units
• DM 6 48,000
• DL 4 32,000
• Variable overhead 1 8,000
• Supervisors salary 3
  24,000
• Depreciation of spec. equip. 2
  16,000
• Allocated general overhead 5
  40,000
• Total cost 21
  168,000

20
Bonner Company make or buy

• Suppose the firm can use the space freed up if
  they do not manufacture to produce another
  product that will contribute 60,000. Should
  they make or buy?

21
Xyon Company make or buy

• Xyon Co. has purchased 10,000 pumps annually from
  Kobec, Inc. Because the price keeps increasing
  and reached 68 per unit last year, Xyons
  management has asked for an estimate of the cost
  of manufacturing the pump in Xyons own
  facilities. Xyon makes stampings and castings
  and has little experience with products requiring
  assembly.
• The engineering, manufacturing, and accounting
  departments have prepared a report for management
  which includes the estimate shown (next slide)
  for an assembly run of 10,000 pumps. Additional
  production employees would be hired to
  manufacture the pumps, but no additional
  equipment, space or supervision would be needed.

22
Xyon Company make or buy

• The report states that total costs for 10,000
  units are estimated at 957,000 or 95.70 per
  unit. The current purchase price is 68 a unit,
  so the report recommends continued purchase of
  the product.
• Components 120,000
• Assembly labor 300,000
• Manufacturing overhead 450,000
• General and admin. Overhead 87,000
• Total costs
  957,000
• Assembly labor consists of hourly production
  workers
• Mfg O/H is applied to products on a DL basis.
  VOH is 50. FOH is 100
• General and admin. is 10 of other costs.

23
Xyon Company make or buy

• Should Xyon make or buy? What is the cost to
  make? To buy?

24
Leland Mfg make or buy

• Leland Mfg. Company uses 10 units of part KJ37
  each month in the production of radar equipment.
  The cost of manufacturing one unit of KJ37 is the
  following
• Direct material 1,000
• Material handling (20 of DM) 200
• Direct labor 8,000
• Manufacturing overhead (150 of DL) 12,000
• Total cost 21,200
• Material handling represents the direct variable
  costs of the Receiving Dept. that are applied to
  direct materials and purchased components on the
  basis of their cost.

25
Leland Mfg. make or buy

• Lelands annual manufacturing overhead budget is
  one-third variable and two-thirds fixed. Scott
  Supply, one of Lelands reliable vendors, has
  offered to supply part number KJ37 at a unit
  price of 15,000.
• 1. If Leland purchases the KJ37 units from
  Scott, the capacity Leland used to mfg. these
  parts would be idle. Should Leland decide to
  purchase the parts from Scott, the unit cost of
  KJ37 would increase (decrease) by what amount?

26
Leland Mfg. make or buy
27
Leland Mfg. make or buy

• Assume Leland Manufacturing is able to rent out
  all of its idle capacity for 25,000 per month.
  If Leland decides to purchase the 10 units from
  Scott Supply, Lelands monthly cost for KJ37
  would increase (decrease) by what amount?

28
Leland Mfg. make or buy

• Assume that Leland Mfg. Does not wish to commit
  to a rental agreement but could use its idle
  capacity to manufacture another product that
  would contribute 52,000 per month. If Leland
  elects to manufacture KJ37 in order to maintain
  quality control, what is the net amount of
  Lelands cost from using the space to manufacture
  part KJ37.

29
Chemung Closing a department

• What is relevant?
• Division contribution - not division profit
• Traceable fixed costs
• Contribution margin - traceable fixed costs
  division contribution

30
Chemung closing a department

• Chemung Metals Co. is considering the elimination
  of its Packaging Dept. Management has received
  an offer from an outside firm to supply all
  Chemungs packaging needs. To help her in making
  the decision, Chemungs president has asked the
  controller for an analysis of the cost of running
  Chemungs Packaging Dept. Included in that
  analysis is 9,100 of rent, which represents the
  Packaging Dept.s allocation of the rent on
  Chemungs factory.
• If the Packaging Dept. is eliminated, the space
  it used will be converted to storage space.
  Currently, Chemung rents storage space in a
  nearby warehouse for 11,000 per year. The
  warehouse rental would no longer be necessary if
  the Packaging Dept. were eliminated.

31
Chemung closing a department

• What is the relevant cost of the space that will
  be freed up if Chemung closes the dept.?
• If Chemung closes its packaging department, the
  department manager will be appointed manager of
  the Cutting Dept. The packaging department
  manager makes 45,000 per year. To hire a new
  Cutting Dept. manager will cost 60,000 per year.
• Is the 45,000 salary relevant?
• Is the 60,000 salary relevant?

32
Day Street Deli dropping a product

• Day Street Delis owner is disturbed by the poor
  profit performance of his ice cream counter. He
  has prepared the following profit analysis.
• Sales 45,000
• Less Cost of food 20,000
• Gross profit 25,000
• Less Operating expenses
• Wages of counter personnel 12,000
• Paper products 4,000
• Utilities (allocated) 2,900
• Depr. Of counter equip. 2,500
• Depr. Of bldg. (allocated) 4,000
• Deli managers salary 3,000Loss on ice
  cream counter (3,400)

33
Day Street Deli dropping a product

• Criticize the owners analysis

34
Thursday

• Hanson Manufacturing case.
• What would happen to income if product 103 were
  dropped? Hanson would lose 103 contribution.
• Also look at the effect of the price change on
  total contribution.

35
Group work

• Answer Super Clean and hand in your solution.