Acct 2220 – Chp 6Relevant Information for Special Decisions

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Learning Objective

LO1LO1

Identify the characteristics of

relevant information.

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Relevant Information

Two primary characteristics distinguish relevant from useless information:

1. Relevant information differs among the alternatives under consideration.

2. Relevant information is future oriented.

Two primary characteristics distinguish relevant from useless information:

1. Relevant information differs among the alternatives under consideration.

2. Relevant information is future oriented.

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Sunk CostA sunk cost has been incurred in a past transaction and cannot be changed. It is

not relevant for making current decisions.

I wish I hadn’t bought that stock. Cost me

$25,000, and now it’s worth only $15,000. I really need a car but don’t have the cash!

I wish I hadn’t bought that stock. Cost me

$25,000, and now it’s worth only $15,000. I really need a car but don’t have the cash!

Just sell the stock and buy the car!

Just sell the stock and buy the car!

You’ve already taken the loss. The $25,000 is a sunk

cost. Like I said, sell the stock and buy the car you need.

You’ve already taken the loss. The $25,000 is a sunk

cost. Like I said, sell the stock and buy the car you need.

I don’t want to take the loss!

I don’t want to take the loss!

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Opportunity CostsAn opportunity cost is the sacrifice that is incurred in order to obtain an alternative

opportunity.

I think I am beginning to see what you mean.

I think I am beginning to see what you mean.

The opportunity cost of owning the stock is $15,000.

That is the amount you could receive if you decide to sell.

The opportunity cost of owning the stock is $15,000.

That is the amount you could receive if you decide to sell.

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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 company’s product line. Projected costs are

shown:

Materials (per unit) 1.50$ Materials (per unit) 2.00$ Direct labor (per unit) 1.00 Direct labor (per unit) 1.00 Supervisor's salary 25,000.00 Supervisor's salary 25,000.00 Franchise fee 50,000.00 Advertising 40,000.00

Cost of Cakes Cost of Pies

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

company’s own name and will require new advertising.

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Relevance is an Independent Concept

Which costs are relevant?

Materials (per unit) 1.50$ Materials (per unit) 2.00$ Direct labor (per unit) 1.00 Direct labor (per unit) 1.00 Supervisor's salary 25,000.00 Supervisor's salary 25,000.00 Franchise fee 50,000.00 Advertising 40,000.00

Cost of Cakes Cost of Pies

Material costs are relevant because they differ. Fifty cents can be avoided by choosing cakes

instead of pies. Labor costs and the supervisor’s salary are not relevant because they do not

differ. The advertising costs can be avoided if the company elects to make cakes. The franchise fee can be avoided if the company elects to

make pies. 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 men’s, women’s, and children’s

clothing. The store manager’s salary could not be eliminated if the store eliminated the line of children’s clothing. Is the store manager’s salary relevant to the

decision to stop selling children’s clothing?

A department store sells men’s, women’s, and children’s

clothing. The store manager’s salary could not be eliminated if the store eliminated the line of children’s clothing. Is the store manager’s salary relevant to the

decision to stop selling children’s clothing?

No, the store manager’s salary will

be the same if children’s clothing is no

longer sold.

No, the store manager’s salary will

be the same if children’s 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 manager’s salary be a relevant cost, if the company was thinking about closing the store completely?

Would the store manager’s 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 manager’s salary. If the store is closed,

the cost will be eliminated.

Yes, it is a relevant cost. If the store remains open, the company will incur the manager’s 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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A quantitative focus considers

the cost, increase in profits, or other numerical aspects of the

decision.

Quantitative Versus Qualitative Characteristics

Relevant information can have both quantitative and qualitative characteristics.

A qualitative focus considers

non-quantitative aspects such as the impact on people and

attractiveness of the products.

For example, suppose you are deciding which of two laptops to purchase. Computer A costs $300 more than Computer B. Both computers satisfy your technical requirements; however

Computer A has a more attractive appearance

Computer A Computer B

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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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Relevant (Avoidable) Costs

Unit-levelCosts

Batch-levelCosts

Product-levelCosts

Facility-levelCosts

Avoided by eliminating oneunit of product.

Avoided when a batch ofwork is eliminated.

Avoided if a product lineis eliminated.

Some costs may be avoidedif a business segment is

eliminated.

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Check Yourself

Aqua, Inc., makes statues for use in fountains. On January 1, 2014, 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, 2016, 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 2016?

Aqua, Inc., makes statues for use in fountains. On January 1, 2014, 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, 2016, 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 2016?

($3,000 – $1,200) ÷ 2 years = $900

($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

LO2LO2

Make appropriatespecial order

decisions.

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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.

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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Unit-level costs Materials costs (2,000 × $90) 180,000$ Labor costs (2,000 × $82.50) 165,000 Overhead (2,000 × $7.50) 15,000 Total unit-level costs 360,000$ Batch-level costs Assembly setup (10 × $1,700) 17,000 Materials handling (10 × $500) 5,000 Total batch-level costs 22,000 Product-level costs Engineering design 14,000 Production manager's salary 63,300 Total product-level costs 77,300 Facility-level costs Segment-level costs 85,000 Division manager's salary 12,700 Company president's salary 43,200 Depreciation 27,300 General expenses 31,000 Total facility-level costs 199,200 Total expected costs 658,500$

Budgeted Cost for Expected Production of 2,000 Printers

Cost per unit : $658,500 ÷ 2,000 = $329.25

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.

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.

Exhibit 6.1

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Special Order DecisionA 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?

Differential revenue ($250 ×200) 50,000$ Avoidable unit-level costs ($180 × 200) (36,000) Avoidable batch-level costs: Assembly setup (1,700) Materials handling (500) Contribution to income 11,800$

Relevant Information for Special Order

If the order is accepted, profitability will increase by $11,800.

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Special Order DecisionOpportunity 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?

Differential revenue ($250 ×200) 50,000$ Avoidable unit-level costs ($180 × 200) (36,000) Avoidable batch-level costs: Assembly setup (1,700) Materials handling (500) Opportunity cost (15,000) Contribution to income (3,200)$

Relevant Information for Special Order

If the order is accepted, profitability will decrease by $3,200.

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Special Order Decision

If Premier can increase income by selling its printers for $250, can the company reduce its normal selling

price to $250?

Revenue ($250 × 2,200) 550,000$ Unit-level costs ($180 × 2,200) 396,000$ Batch-level costs (11 × $2,200) 24,200 Production-level costs 77,300 Facility-level costs 199,200 Total cost 696,700 Projected loss (146,700)$

Selling 2,200 Printers for $250 Per Unit

Relevance and the Decision Context

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Special Order Decision

Should a company ever reject a special order if the relevant revenues exceed the relevant

costs?

Qualitative Characteristics

What will happen if Premier’s regular customers learn that the company sold

printers to another buyer for $250 per unit?

What will happen if Premier’s regular customers learn that the company sold

printers to another buyer for $250 per unit?

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Learning Objective

LO3LO3

Make appropriateoutsourcing decisions.

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Outsourcing DecisionsCompanies 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?

That test was so easy. How did you

score so low?

I outsourced my homework!!

I outsourced my homework!!

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Outsourcing DecisionsLet’s 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 1: Determine the production costs Premier can avoid if it elects to outsource printer production.Step 1: Determine the production costs Premier can avoid if it elects to outsource printer production.

Unit-level costs ($180 × 2,000) 360,000$ Batch-level costs ($2,200 x 10) 22,000 Product-level costs 77,300 Total relevant cost 459,300$

Relevent Costs for 2,000 Printers

Cost per unit = $459,300 ÷ 2,000 = $229.65Cost per unit = $459,300 ÷ 2,000 = $229.65

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Outsourcing Decisions

Step 2:Compare the avoidable production costs with the cost ofbuying the product and select the lower-cost option.

Step 2:Compare the avoidable production costs with the cost ofbuying the product and select the lower-cost option.

Purchase price per unit 240.00$ Relevant cost per unit 229.65 In favor of manufacturing 10.35 Number of printers 2,000 Profit decline by outsourcing 20,700$

Comparison

Premier should reject the outsourcing offer.

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Outsourcing DecisionsOpportunity 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?

Unit-level costs ($180 × 2,000) 360,000$ Batch-level costs ($2,200 x 10) 22,000 Product-level costs 77,300 Opportunity cost of warehouse 40,000 Total relevant cost 499,300$

Relevant Costs for 2,000 Printers

Cost per unit = $499,300 ÷ 2,000 = $249.65Cost per unit = $499,300 ÷ 2,000 = $249.65

Management should purchase the printersbecause the price of $240 is below the cost of

$249.65 when the opportunity cost is factored in.

Management should purchase the printersbecause the price of $240 is below the cost of

$249.65 when the opportunity cost is factored in.

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Evaluating Growth on 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.

Unit-level costs ($180 × 3,000) 540,000$ Batch-level costs ($2,200 × 15) 33,000 Product-level costs 77,300 Opportunity cost 40,000 Total relevant cost 690,300$

Relevant Costs for 3,000 Printers

Cost per unit = $690,300 ÷ 3,000 = $230.10Cost per unit = $690,300 ÷ 3,000 = $230.10

Management should reject the offer, but if growthis expected in the future it must be factored into

management’s decision.

Management should reject the offer, but if growthis expected in the future it must be factored into

management’s decision.

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Qualitative FeaturesA 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 company’s control over its

production to outside suppliers.

Outsourcing reduces the level of vertical integration,passing some of a company’s control over its

production to outside suppliers.

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Learning Objective

LO4LO4

Make appropriatesegment elimination

decisions.

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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. Let’s look at a segment report for Premier Office Products that has divided its

operations into three segments: (1) copiers, (2) computers, and (3) printers.

6-32Should management eliminate the copier segment?

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Segment Elimination Decisions

A three step decision:

1. Determine the amount of relevant revenue that pertains to eliminating the segment.

2. Determine the amount of cost that can be avoided if the segment is eliminated.

3. If the relevant revenue is less than the avoidable cost, eliminate the segment. If not, continue to operate it.

A three step decision:

1. Determine the amount of relevant revenue that pertains to eliminating the segment.

2. Determine the amount of cost that can be avoided if the segment is eliminated.

3. 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 1:If 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.

Step 1:If 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 2:If Premier eliminates copiers, it will avoid the following costs:

Step 2:If Premier eliminates copiers, it will avoid the following costs:

Unit-level costs Materials costs (120,000)$ Labor costs (160,000) Overhead (30,800) Batch-level costs Assembly setup (15,000) Materials handling (6,000) Product-level costs Engineering costs (10,000) Production manager salary (52,000) Facility-level costs Segment level Division manager salary (82,000) Administrative costs (12,200) Total relevant costs (488,000)$

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Segment Elimination Decisions

Step 3:If Premier eliminates copiers, its profits will decrease:

Step 3:If Premier eliminates copiers, its profits will decrease:

Revenue lost (550,000)$ Costs avoided 488,000 Decrease in profit (62,000)$

The corporate-level facility-sustaining costs will not be eliminated, but will be allocated to the

remaining segments.

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Qualitative Considerations

1. Employee lives will be disrupted.

2. Sales of different product lines are frequently interdependent.

3. What will happen to the space freed by the eliminated segment?

4. Volume changes can affect elimination decisions.

1. Employee lives will be disrupted.

2. Sales of different product lines are frequently interdependent.

3. What will happen to the space freed by the eliminated segment?

4. Volume changes can affect elimination decisions.

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Relationships Between Avoidable Costs and Business Activities

1. Special order decisions affect unit-level and possibly batch-level costs.

2. Outsourcing can avoid many product-level as well as unit- and batch-level costs.

3. Segment elimination can avoid some of the facility-level costs.

1. Special order decisions affect unit-level and possibly batch-level costs.

2. Outsourcing can avoid many product-level as well as unit- and batch-level costs.

3. 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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End of Chapter 6