Agenda

1
Agenda

• Discussion of relevant information
• Group problem solving

2
Relevant costs and revenues

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

3
Kinds of decisions

• Purchase of new equipment
• Special orders
• Dropping/adding a product line
• Dropping/adding a segment
• Make or buy (sourcing)
• Sell or process further

4
Important information characteristics

• Accurate
• Timely
• Relevant

5
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 do not differ across decision
alternatives
6
Other cost concepts

• Outlay costs
• Opportunity costs

Out-of-pocket Costs
7
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 sufficient idle capacity?
• Have all opportunity costs been considered?
• Are there strategic issues not captured by the
  financial analysis that should be considered?

8
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.

9
Interlaken Chemical Company

• For this problem, we just want to know what the
  relevant cost of theolite is?
• Replacement cost (2.40 x 8000 19,200)
• Historical cost (2 x 8000 16,000)
• The sales value (14,500)
• This is the opportunity cost of the theolite.
• What would the relevant theolite cost be if we
  could not sell it?

10
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.

11
Interlaken Chemical Company

• What is the relevant cost of genatope?
• Historical cost (8.10 x 1000 8,100)
• Replacement cost of the genatope 8,300
• Cost of the rush order (5000 x .40) 2,000
• Total cost 10,300

12
Group Exercise

• Orangebo

13
Bonner Company make or buy (sourcing)

• 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

112,000
Buy 8000 x 19 152,000
14
Bonner Company make or buy (sourcing)

• 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?
• Make 112,000 60,000 172,000
• Buy 19 x 8000 152,000

15
Leland Mfg make or buy (sourcing)

• 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.

16
Leland Mfg. make or buy (sourcing)

• 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?

17
Leland Mfg. make or buy (sourcing)

• Make
• DM 1,000
• Handling 200
• DL 8,000
• Mfg. O/H 4,000
• Unit cost 13,200
• Buy 15,000 3,000 18,000
• Cost increases by 4,800.

18
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?
• Make 13,200 x 10 132,000 monthly cost to
  mfg.
  25,000 opp. cost to mfg.
• 157,000 total cost to mfg.
• Buy 18,000 x 10 180,000
• Increase 180,000 - 157,000 23,000

19
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.
• Make 132,000 52,000 184,000
• Buy 180,000
• Net cost 4,000

20
Relevant costs/capacity

• Day 2

21
Day 2

• Air Frisco, Grossman
• Start with review problems
• Special order
• Adding/dropping product lines
• Product profitability
• Product contribution and decision making

22
Decision making concept review

• Contribution (unit, product line, division,
  factory, subsidiary, . . . )
• Relevant financial data To be relevant, the
  value must change across decision alternatives
• Opportunity costs
• Outlay costs
• Avoidable costs

23
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 sufficient idle capacity?
• Have all opportunity costs been considered?
• Are there strategic issues not captured by the
  financial analysis that should be considered?

24
Special Order Review

• Elizah Corporation

25
Profitability of segments

• A segment is any piece of a business it makes
  sense to isolate (product, product line,
  department, division, subsidiary)
• Look for segment contribution
• Traceable revenues less traceable costs. Those
  are typically avoidable.
• Not segment accounting income.

26
Closing a department

• What is relevant?
• Department contribution - not department profit
• unavoidable fixed costs
• Operating profit/loss unavoidable fixed costs.
• Or Revenues minus avoidable costs.

27
Closing a Department

• Day Street Deli

28
Product profitability

• Question to be answered Which of the products
  should be emphasized in the future?
• What would you want to know to answer that
  question?
• Do you want to use last years total product
  profit?
• Do you want to use last years total product
  contribution?

29
Choosing a product from among alternative designs

• Substitute products, similar unit demand
• Same or differing fixed costs
• Constrained resources
• A level of demand defined by dollars instead of
  units
• Uncertain demand

30
Assessing Product ProfitabilitySteven Company
First three parts
31
Group ProblemThink Contribution!!

• Air Frisco

32
Common Pitfalls

• Sunk costs (A common behavioral tendency is to
  give undue important to book values)
• Unitized fixed costs (For financial reporting
  purposes fixed costs are divided by some activity
  measure and assigned to units of product. The
  result is to make a fixed cost appear variable.)
• Allocated fixed costs (A possible result is that
  a product or department may appear unprofitable
  as a function of the allocation method chosen.)
• Opportunity costs (People tend to overlook
  opportunity costs, or to treat them as less
  important than out-of-pocket costs.)

33
Dropping Segments

• Grossman

34
Common Pitfalls

• Ignoring bottlenecks, orconstraints.
• Steven Co. on Wednesday

35
Prestige Telephone Co.

• What would happen to telephone company income if
  the data processing operation were dropped?
  (relevant costs)
• Of the set of alternatives suggested for
  salvaging the data processing operation, which
  makes the most sense? (CVP analysis)
• Why is Prestige Data Services continuing to
  report losses?

36
The end!