11 - 1 Decision Making and Decision Making and Relevant Information Relevant Information Chapter 11 Chapter 11
Dec 19, 2015
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Decision Making and Decision Making and Relevant InformationRelevant Information
Chapter 11Chapter 11
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IntroductionIntroduction
This chapter explores the decision-making This chapter explores the decision-making process.process.
It focuses on specific decisions such as It focuses on specific decisions such as accepting or rejecting a one-time-only special accepting or rejecting a one-time-only special order, insourcing or outsourcing products or order, insourcing or outsourcing products or services, and replacing or keeping equipment.services, and replacing or keeping equipment.
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Learning ObjectivesLearning Objectives
1 Use the five-step decision process to make Use the five-step decision process to make decisionsdecisions
2 Differentiate relevant costs and revenues from Differentiate relevant costs and revenues from irrelevant costs and revenues in any decision irrelevant costs and revenues in any decision situationsituation
3 Distinguish between quantitative factors and Distinguish between quantitative factors and qualitative factors in decisionsqualitative factors in decisions
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Learning ObjectivesLearning Objectives
4 Identify two potential problems that should Identify two potential problems that should be avoided in relevant-cost analysisbe avoided in relevant-cost analysis
5 Describe the opportunity cost concept and Describe the opportunity cost concept and explain why it is used in decision makingexplain why it is used in decision making
6 Describe the key concept in choosing which Describe the key concept in choosing which among multiple products to produce when among multiple products to produce when there are capacity constraintsthere are capacity constraints
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Learning ObjectivesLearning Objectives
7 Discuss the key factor managers must consider Discuss the key factor managers must consider when adding or dropping customers and segmentswhen adding or dropping customers and segments
8 Explain why the book value of equipment is Explain why the book value of equipment is irrelevant in equipment-replacement decisionsirrelevant in equipment-replacement decisions
9 Explain how conflicts can arise between the Explain how conflicts can arise between the decision model used by a manager and the decision model used by a manager and the performance model used to evaluate the managerperformance model used to evaluate the manager
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Learning Objective 1Learning Objective 1
Use the five-step decision Use the five-step decision process to make decisionsprocess to make decisions
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Information and the Information and the Decision ProcessDecision Process
A decision model is a formal method for A decision model is a formal method for making a choice, often involving quantitative making a choice, often involving quantitative and qualitative analysis.and qualitative analysis.
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Five-Step Decision ProcessFive-Step Decision Process
1 Gathering informationGathering information2 Making predictionsMaking predictions3 Choosing an alternativeChoosing an alternative4 Implementing the decisionImplementing the decision5 Evaluating performanceEvaluating performance
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Learning Objective 2Learning Objective 2
Differentiate relevant costs Differentiate relevant costs and revenues from irrelevant and revenues from irrelevant
costs and revenues in any costs and revenues in any decision situationdecision situation
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The Meaning of RelevanceThe Meaning of Relevance
Relevant costs and relevant revenues are Relevant costs and relevant revenues are expected future costs and revenues that differ expected future costs and revenues that differ among alternative courses of action.among alternative courses of action.
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The Meaning of RelevanceThe Meaning of Relevance
Historical costs are irrelevant to a decision but Historical costs are irrelevant to a decision but are used as a basis for predicting future costs.are used as a basis for predicting future costs.
Sunk costs are past costs which are Sunk costs are past costs which are unavoidable.unavoidable.
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The Meaning of RelevanceThe Meaning of Relevance
Differential income (net relevant income) is Differential income (net relevant income) is the difference in total operating income when the difference in total operating income when choosing between two alternatives.choosing between two alternatives.
Differential costs (net relevant costs) are the Differential costs (net relevant costs) are the difference in total costs between two difference in total costs between two alternatives.alternatives.
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Learning Objective 3Learning Objective 3
Distinguish between Distinguish between quantitative factors and quantitative factors and
qualitative factors in decisionsqualitative factors in decisions
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Quantitative and Qualitative Quantitative and Qualitative Relevant InformationRelevant Information
Quantitative factors are outcomes that are Quantitative factors are outcomes that are measured in numerical terms:measured in numerical terms:
– FinancialFinancial– NonfinancialNonfinancial Qualitative factors are outcomes that cannot Qualitative factors are outcomes that cannot
be measured in numerical terms.be measured in numerical terms.
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One-Time-Only Special OrderOne-Time-Only Special Order
Gabriela & Co. manufactures fancy bath towels Gabriela & Co. manufactures fancy bath towels in Boone, North Carolina.in Boone, North Carolina.
The plant has a production capacity of 44,000 The plant has a production capacity of 44,000 towels each month.towels each month.
Current monthly production is 30,000 towels.Current monthly production is 30,000 towels. The assumption is made that costs can be The assumption is made that costs can be
classified as either variable with respect to units classified as either variable with respect to units of output or fixed.of output or fixed.
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One-Time-Only Special OrderOne-Time-Only Special Order
Variable Fixed Variable Fixed Costs Costs Costs Costs Per UnitPer Unit Per Unit Per Unit Direct materialsDirect materials $6.50$6.50 $ -0- $ -0- Direct labor Direct labor .50 .50 1.50 Manufacturing costs1.50 Manufacturing costs 1.50 1.50 3.50 3.50 TotalTotal $8.50$8.50 $5.00$5.00
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One-Time-Only Special OrderOne-Time-Only Special Order
Total fixed direct manufacturing labor Total fixed direct manufacturing labor amounts to $45,000.amounts to $45,000.
Total fixed overhead is $105,000.Total fixed overhead is $105,000. Marketing costs per unit are $7 ($5 of which Marketing costs per unit are $7 ($5 of which
is variable).is variable). What is the full cost per towel?What is the full cost per towel?
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One-Time-Only Special OrderOne-Time-Only Special Order
Variable ($8.50 + $5.00):Variable ($8.50 + $5.00): $13.50$13.50 Fixed:Fixed: 7.00 7.00 TotalTotal $20.50$20.50 A hotel in Puerto Rico has offered to buy A hotel in Puerto Rico has offered to buy
5,000 towels from Gabriela & Co. at $11.50 5,000 towels from Gabriela & Co. at $11.50 per towel for a total of $57,500.per towel for a total of $57,500.
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One-Time-Only Special OrderOne-Time-Only Special Order
No marketing costs will be incurred for this No marketing costs will be incurred for this one-time-only special order.one-time-only special order.
Should Gabriela & Co. accept this order?Should Gabriela & Co. accept this order? Yes!Yes! Why?Why?
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One-Time-Only Special OrderOne-Time-Only Special Order
The relevant costs of making the towels are The relevant costs of making the towels are $42,500.$42,500.
$8.50 × 5,000 = $42,500 incremental costs$8.50 × 5,000 = $42,500 incremental costs $57,500 – $42,500 = $15,000 incremental $57,500 – $42,500 = $15,000 incremental
revenuesrevenues $11.50 – $8.50 = $3.00 contribution margin $11.50 – $8.50 = $3.00 contribution margin
per towelper towel
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One-Time-Only Special OrderOne-Time-Only Special Order
Decision criteria: Decision criteria: Accept the order if the revenue differential Accept the order if the revenue differential
is greater than the cost differential.is greater than the cost differential.
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Learning Objective 4Learning Objective 4
Identify two potential problems Identify two potential problems that should be avoided in that should be avoided in
relevant-cost analysisrelevant-cost analysis
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Potential Problems in Potential Problems in Relevant-Cost AnalysisRelevant-Cost Analysis
General assumptions:General assumptions:– Do not assume that all variable costs are Do not assume that all variable costs are
relevant.relevant.– Do not assume that all fixed costs are Do not assume that all fixed costs are
irrelevant.irrelevant.
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Potential Problems in Potential Problems in Relevant-Cost AnalysisRelevant-Cost Analysis
Unit-cost data can potentially mislead Unit-cost data can potentially mislead decision makers:decision makers:
– Irrelevant costs are included.Irrelevant costs are included.– The same unit costs are used at different The same unit costs are used at different
output levels.output levels.
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Insourcing versus OutsourcingInsourcing versus Outsourcing
OutsourcingOutsourcing is the process of purchasing is the process of purchasing goods and services from outside vendors goods and services from outside vendors rather than producing goods or providing rather than producing goods or providing services within the organization, which is services within the organization, which is called called insourcinginsourcing..
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Make-or-Buy DecisionsMake-or-Buy Decisions
Decisions about whether to outsource or Decisions about whether to outsource or produce within the organization are often produce within the organization are often called make-or-buy decisions.called make-or-buy decisions.
The most important factors in the make-or-buy The most important factors in the make-or-buy decision are quality, dependability of supplies, decision are quality, dependability of supplies, and costs.and costs.
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Make-or-Buy DecisionsMake-or-Buy Decisions
Gabriela & Co. also manufactures bath Gabriela & Co. also manufactures bath accessories.accessories.
Management is considering producing a Management is considering producing a part it needs (#2) or using a part produced part it needs (#2) or using a part produced by Alec Enterprises.by Alec Enterprises.
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Make-or-Buy DecisionsMake-or-Buy Decisions
Gabriela & Co. has the following costs for Gabriela & Co. has the following costs for 150,000 units of Part #2:150,000 units of Part #2:
Direct materialsDirect materials $ 28,000 Direct $ 28,000 Direct laborlabor 18,500 Mixed 18,500 Mixed overheadoverhead 29,000 Variable 29,000 Variable overheadoverhead 15,000 Fixed 15,000 Fixed overheadoverhead 30,000 30,000 TotalTotal
$120,500$120,500
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Make-or-Buy DecisionsMake-or-Buy Decisions
Mixed overhead consists of material handling Mixed overhead consists of material handling and setup costs.and setup costs.
Gabriela & Co. produces the 150,000 units in Gabriela & Co. produces the 150,000 units in 100 batches of 1,500 units each.100 batches of 1,500 units each.
Total material handling and setup costs equal Total material handling and setup costs equal fixed costs of $9,000 plus variable costs of fixed costs of $9,000 plus variable costs of $200 per batch.$200 per batch.
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Make-or-Buy DecisionsMake-or-Buy Decisions
What is the cost per unit for Part #2?What is the cost per unit for Part #2? $120,500 ÷ 150,000 units = $0.8033/unit$120,500 ÷ 150,000 units = $0.8033/unit Alec Enterprises offers to sell the same part Alec Enterprises offers to sell the same part
for $0.55.for $0.55. Should Gabriela & Co. manufacture the part Should Gabriela & Co. manufacture the part
or buy it from Alec Enterprises?or buy it from Alec Enterprises?
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Make-or-Buy DecisionsMake-or-Buy Decisions
The answer depends on the difference in The answer depends on the difference in expected future costs between the alternatives.expected future costs between the alternatives.
Gabriela & Co. anticipates that next year the Gabriela & Co. anticipates that next year the 150,000 units of Part #2 expected to be sold 150,000 units of Part #2 expected to be sold will be manufactured in 150 batches of 1,000 will be manufactured in 150 batches of 1,000 units each.units each.
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Make-or-Buy DecisionsMake-or-Buy Decisions
Variable costs per batch are expected to Variable costs per batch are expected to decrease to $100. decrease to $100.
Gabriela & Co. plans to continue to produce Gabriela & Co. plans to continue to produce 150,000 next year at the same variable 150,000 next year at the same variable manufacturing costs per unit as this year.manufacturing costs per unit as this year.
Fixed costs are expected to remain the same Fixed costs are expected to remain the same as this year.as this year.
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Make-or-Buy DecisionsMake-or-Buy Decisions
What is the variable manufacturing cost What is the variable manufacturing cost per unit?per unit?
Direct materialDirect material $28,000 Direct $28,000 Direct laborlabor 18,500 Variable 18,500 Variable overheadoverhead 15,000 15,000 Total Total
$61,500$61,500 $61,500 ÷ 150,000 = $0.41 per unit$61,500 ÷ 150,000 = $0.41 per unit
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Make-or-Buy DecisionsMake-or-Buy Decisions
Expected relevant cost to make Part #2:Expected relevant cost to make Part #2: ManufacturingManufacturing $61,500 $61,500
Material handling and setupsMaterial handling and setups 15,000 15,000* * Total relevant cost to makeTotal relevant cost to make $76,500 *150 $76,500 *150 × $100 = $15,000× $100 = $15,000
Cost to buy: (150,000 × $0.55)Cost to buy: (150,000 × $0.55) $82,500$82,500 Gabriela & Co. will save $6,000 by making the Gabriela & Co. will save $6,000 by making the
part.part.
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Make-or-Buy DecisionsMake-or-Buy Decisions
Now assume that the $9,000 in fixed clerical Now assume that the $9,000 in fixed clerical salaries to support material handling and setup salaries to support material handling and setup will not be incurred if Part #2 is purchased will not be incurred if Part #2 is purchased from Alec Enterprises.from Alec Enterprises.
Should Gabriela & Co. buy the part or make Should Gabriela & Co. buy the part or make the part?the part?
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Make-or-Buy DecisionsMake-or-Buy Decisions
Relevant cost to make:Relevant cost to make: VariableVariable $76,500 $76,500
FixedFixed 9,000 9,000 TotalTotal $85,500$85,500
Cost to buy:Cost to buy: $82,500$82,500 Gabriela would save $3,000 by buying Gabriela would save $3,000 by buying
the part.the part.
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Learning Objective 5Learning Objective 5
Describe the opportunity cost Describe the opportunity cost concept and explain why it is concept and explain why it is
used in decision makingused in decision making
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
Assume that if Gabriela buys the part from Assume that if Gabriela buys the part from Alec Enterprises, it can use the facilities Alec Enterprises, it can use the facilities previously used to manufacture Part #2 to previously used to manufacture Part #2 to produce Part #3 for Krysta’s Company.produce Part #3 for Krysta’s Company.
The expected additional future operating The expected additional future operating income is $18,000.income is $18,000.
What should Gabriela & Co. do?What should Gabriela & Co. do?
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
Gabriela & Co. has three options:Gabriela & Co. has three options:1 Make Part #2 and do not make Part #3 for Make Part #2 and do not make Part #3 for
Krysta.Krysta.2 Buy Part #2 and do not make Part #3 for Buy Part #2 and do not make Part #3 for
Krysta.Krysta.3 Buy the part and use the facilities to produce Buy the part and use the facilities to produce
Part #3 for Krysta.Part #3 for Krysta.
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
Expected cost of obtaining 150,000 parts:Expected cost of obtaining 150,000 parts: Buy Part #2Buy Part #2 Buy Part #2Buy Part #2
and do not and do not and makeand make Make Make make Part #3make Part #3 Part #3Part #3 Part #2 Part #2 $82,500 $82,500 $64,500*$64,500* $76,500$76,500
*$82,500 – $18,000 = $64,500*$82,500 – $18,000 = $64,500
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
Opportunity cost is the contribution to income Opportunity cost is the contribution to income that is foregone (rejected) by not using a that is foregone (rejected) by not using a limited resource in its next-best alternative limited resource in its next-best alternative use.use.
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
Opportunity costs are not recorded in formal Opportunity costs are not recorded in formal accounting records since they do not generate accounting records since they do not generate cash outlays. cash outlays.
These costs also are not ordinarily These costs also are not ordinarily incorporated into formal reports.incorporated into formal reports.
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
The opportunity cost of holding inventory is The opportunity cost of holding inventory is the income forgone from tying up money in the income forgone from tying up money in inventory and not investing it elsewhere.inventory and not investing it elsewhere.
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
Carrying costs of inventory can be a Carrying costs of inventory can be a significant opportunity cost and should be significant opportunity cost and should be incorporated into decisions regarding lot incorporated into decisions regarding lot purchase sizes for materials.purchase sizes for materials.
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
Assume that annual estimated Part #2 Assume that annual estimated Part #2 requirements for next year is 150,000.requirements for next year is 150,000.
Cost per purchase order is $40.Cost per purchase order is $40. Cost per unit when each purchase is of 1,500 Cost per unit when each purchase is of 1,500
units = $0.55. units = $0.55. Cost per unit when each purchase is equal to Cost per unit when each purchase is equal to
or greater than 150,000 = $0.54.or greater than 150,000 = $0.54.
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
Average investment in inventory is either:Average investment in inventory is either: (1,500 x .55) ÷ 2 = $412.50 or(1,500 x .55) ÷ 2 = $412.50 or (150,000 x $0.54) = $40,500(150,000 x $0.54) = $40,500 Annual interest rate for investment in Annual interest rate for investment in
government bonds is 6%.government bonds is 6%. $412.50 × .06 = $24.75$412.50 × .06 = $24.75 $40,500 × .06 = $2,430$40,500 × .06 = $2,430
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
Option A: Make 100 purchases of 1,500 units:Option A: Make 100 purchases of 1,500 units: Purchase order costs: (100 × $40)Purchase order costs: (100 × $40)$ 4,000.00$ 4,000.00 Purchase costs: (150,000 × $0.55)Purchase costs: (150,000 × $0.55) 82,500.00 82,500.00 Annual interest income that Annual interest income that
could be earned:could be earned: 24.75 24.75 Relevant costsRelevant costs $86,524.75$86,524.75
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
Option B: Make 1 purchase of 150,000 units:Option B: Make 1 purchase of 150,000 units: Purchase order costs: (1 × $40)Purchase order costs: (1 × $40) $ 40$ 40 Purchase costs: (150,000 × $0.54)Purchase costs: (150,000 × $0.54) 81,000 81,000 Annual interest income Annual interest income
that could be earned:that could be earned: 2,430 2,430 Relevant costs:Relevant costs: $83,470$83,470
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Opportunity Costs, Outsourcing, Opportunity Costs, Outsourcing, and Constraintsand Constraints
In this case purchasing all 150,000 units In this case purchasing all 150,000 units at the beginning of the year is preferred.at the beginning of the year is preferred.
Why?Why? The higher purchase and ordering costs The higher purchase and ordering costs
exceeds the lower opportunity cost of exceeds the lower opportunity cost of holding smaller inventory.holding smaller inventory.
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Learning Objective 6Learning Objective 6
Describe the key concept in Describe the key concept in choosing which among multiple choosing which among multiple products to produce when there products to produce when there
are capacity constraintsare capacity constraints
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Product-Mix Decisions Under Product-Mix Decisions Under Capacity ConstraintsCapacity Constraints
What product should be emphasized to What product should be emphasized to maximize operating income in the face of maximize operating income in the face of capacity constraints?capacity constraints?
Gabriela & Co. produces Product #2 and Gabriela & Co. produces Product #2 and Product #3.Product #3.
The company has 3,000 machine hours The company has 3,000 machine hours available to produce these products.available to produce these products.
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Product-Mix Decisions Under Product-Mix Decisions Under Capacity ConstraintsCapacity Constraints
Decision criteria:Decision criteria: Aim for the highest contribution margin per Aim for the highest contribution margin per unit of the constraining factor.unit of the constraining factor.
When multiple constraints exist, optimization When multiple constraints exist, optimization techniques such as linear programming can be techniques such as linear programming can be used in making decisions.used in making decisions.
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Product-Mix Decisions Under Product-Mix Decisions Under Capacity ConstraintsCapacity Constraints
Per unitPer unit Product #2Product #2 Product #3 Product #3 Sales priceSales price $2.11$2.11 $14.50 $14.50 Variable expensesVariable expenses 0.41 0.41 13.90 13.90 Contribution marginContribution margin $1.70$1.70 $ 0.60$ 0.60
Contribution margin ratio 81% 4%Contribution margin ratio 81% 4%
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Product-Mix Decisions Under Product-Mix Decisions Under Capacity ConstraintsCapacity Constraints
One unit of Prod. #2 requires 7 machine hours.One unit of Prod. #2 requires 7 machine hours. One unit of Prod. #3 requires 2 machine hours.One unit of Prod. #3 requires 2 machine hours. What is the contribution of each product per What is the contribution of each product per
machine hour?machine hour? Product #2: $1.70 ÷ 7 = $0.24Product #2: $1.70 ÷ 7 = $0.24 Product #3: $0.60 ÷ 2 = $0.30Product #3: $0.60 ÷ 2 = $0.30
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Product-Mix Decisions Under Product-Mix Decisions Under Capacity ConstraintsCapacity Constraints
Which product should be emphasized?Which product should be emphasized? The product with the highest contribution The product with the highest contribution
margin per unit of the constraining resource.margin per unit of the constraining resource.
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Learning Objective 7Learning Objective 7
Discuss the key factor managers Discuss the key factor managers must consider when adding or must consider when adding or
dropping customers and dropping customers and segmentssegments
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Profitability, Activity-Based Profitability, Activity-Based Costing, and Relevant CostsCosting, and Relevant Costs
Companies must often make decisions about Companies must often make decisions about adding or discontinuing a product line, branch, adding or discontinuing a product line, branch, or business segment.or business segment.
Companies must also make decisions about Companies must also make decisions about adding or dropping customers.adding or dropping customers.
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Profitability, Activity-Based Profitability, Activity-Based Costing, and Relevant CostsCosting, and Relevant Costs
Blowing Rock Furniture supplies specialized Blowing Rock Furniture supplies specialized furniture to two local retailers – Stevens and furniture to two local retailers – Stevens and Cohen.Cohen.
Blowing Rock Furniture has a monthly Blowing Rock Furniture has a monthly capacity of 3,000 machine hours.capacity of 3,000 machine hours.
Fixed costs are allocated on the basis of Fixed costs are allocated on the basis of revenues.revenues.
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Profitability, Activity-Based Profitability, Activity-Based Costing, and Relevant CostsCosting, and Relevant Costs
StevensStevens Cohen Cohen Revenues Revenues $200,000$200,000$100,000 Variable costs$100,000 Variable costs
70,000 70,000 60,000 Fixed 60,000 Fixed costscosts 100,000 100,000 50,000 50,000 Total operating costsTotal operating costs $170,000$170,000 $110,000 $110,000 Operating income Operating income
$ 30,000$ 30,000 $ (10,000) Machine-$ (10,000) Machine-hours requiredhours required 2,000 2,000 1,000 1,000
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Profitability, Activity-Based Profitability, Activity-Based Costing, and Relevant CostsCosting, and Relevant Costs
Total Total Revenues Revenues$300,000 Variable costs$300,000 Variable costs
130,000 Fixed costs 130,000 Fixed costs 150,000 150,000 Total operating costs Total operating costs$280,000 Operating income$280,000 Operating income $ $
20,000 Machine-hours required 20,000 Machine-hours required 3,0003,000
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Profitability, Activity-Based Profitability, Activity-Based Costing, and Relevant CostsCosting, and Relevant Costs
Should Blowing Rock Furniture drop the Should Blowing Rock Furniture drop the Cohen business, assuming that dropping Cohen business, assuming that dropping Cohen would decrease its total fixed costs Cohen would decrease its total fixed costs by 10%?by 10%?
New fixed costs would be: New fixed costs would be: $150,000 – $15,000 = $135,000$150,000 – $15,000 = $135,000
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Profitability, Activity-Based Profitability, Activity-Based Costing, and Relevant CostsCosting, and Relevant Costs
Stevens Alone Stevens Alone RevenuesRevenues $200,000 $200,000 Variable costsVariable costs 70,000 70,000 Fixed costs Fixed costs 135,000 135,000 Total operating costsTotal operating costs $205,000 Operating $205,000 Operating incomeincome $ (5,000) Machine-$ (5,000) Machine-hours required 3,000hours required 3,000
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Profitability, Activity-Based Profitability, Activity-Based Costing, and Relevant CostsCosting, and Relevant Costs
Cohen’s business is providing a contribution Cohen’s business is providing a contribution margin of $40,000.margin of $40,000.
$40,000 decrease in contribution margin – $40,000 decrease in contribution margin – $15,000 decrease in fixed costs = $25,000 $15,000 decrease in fixed costs = $25,000 decrease in operating income.decrease in operating income.
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Profitability, Activity-Based Profitability, Activity-Based Costing, and Relevant CostsCosting, and Relevant Costs
Assume that if Blowing Rock Furniture drops Assume that if Blowing Rock Furniture drops Cohen’s business it can lease the excess Cohen’s business it can lease the excess capacity to the Perez Corporation for $50,000.capacity to the Perez Corporation for $50,000.
Fixed costs would not decrease.Fixed costs would not decrease. Should Blowing Rock Furniture lease to Should Blowing Rock Furniture lease to
Perez?Perez?
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Profitability, Activity-Based Profitability, Activity-Based Costing, and Relevant CostsCosting, and Relevant Costs
$50,000 would be Blowing Rock Furniture’s $50,000 would be Blowing Rock Furniture’s opportunity cost of continuing serving Cohen.opportunity cost of continuing serving Cohen.
The $50,000 offsets the $40,000 contribution The $50,000 offsets the $40,000 contribution of Cohen’s business.of Cohen’s business.
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Learning Objective 8Learning Objective 8
Explain why the book value Explain why the book value of equipment is irrelevant in of equipment is irrelevant in
equipment-replacement equipment-replacement decisionsdecisions
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Equipment-Replacement Equipment-Replacement DecisionsDecisions
Assume that Gabriela & Co. is considering Assume that Gabriela & Co. is considering replacing a cutting machine with a newer replacing a cutting machine with a newer model.model.
The new machine is more efficient than the The new machine is more efficient than the old machine.old machine.
Revenues will be unaffected.Revenues will be unaffected.
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Equipment-Replacement Equipment-Replacement DecisionsDecisions
Existing ReplacementExisting Replacement MachineMachine MachineMachine
Original costOriginal cost $80,000 $105,000 $80,000 $105,000 Useful life Useful life 4 years 4 years 4 years 4 years Accumulated depreciation $50,000 Accumulated depreciation $50,000 Book valueBook value $30,000 $30,000 Disposal price Disposal price $14,000 $14,000 Annual costs Annual costs $46,000 $46,000 $ 10,000 $ 10,000
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Equipment-Replacement Equipment-Replacement DecisionsDecisions
Ignoring the time value of money and income Ignoring the time value of money and income taxes, should Gabriela replace the existing taxes, should Gabriela replace the existing machine?machine?
Yes!Yes! The cost savings per year are $36,000.The cost savings per year are $36,000. The cost savings over a 4-year period will be The cost savings over a 4-year period will be
$36,000 × 4 = $144,000.$36,000 × 4 = $144,000.
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Equipment-Replacement Equipment-Replacement DecisionsDecisions
Investment = $105,000 – $14,000 = $91,000 Investment = $105,000 – $14,000 = $91,000 $144,000 – $91,000 = $53,000 advantage of $144,000 – $91,000 = $53,000 advantage of
the replacement machine.the replacement machine.
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Irrelevance of Past CostsIrrelevance of Past Costs
The book value of existing equipment is The book value of existing equipment is irrelevant since it is neither a future cost nor irrelevant since it is neither a future cost nor does it differ among any alternatives (sunk does it differ among any alternatives (sunk costs never differ).costs never differ).
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Irrelevance of Past CostsIrrelevance of Past Costs
The disposal price of old equipment and the The disposal price of old equipment and the purchase cost of new equipment are relevant purchase cost of new equipment are relevant costs and revenues because...costs and revenues because...
– they are future costs or revenues that differ they are future costs or revenues that differ between alternatives to be decided upon.between alternatives to be decided upon.
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Learning Objective 9Learning Objective 9
Explain how conflicts can arise Explain how conflicts can arise between the decision model between the decision model used by a manager and the used by a manager and the performance model used to performance model used to
evaluate the managerevaluate the manager
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Decisions and Performance Decisions and Performance EvaluationEvaluation
What is the journal entry to sell the existing What is the journal entry to sell the existing machine?machine?
CashCash 14,000 14,000 Accumulated Accumulated DepreciationDepreciation 50,000 50,000 Loss on disposalLoss on disposal16,000 16,000 Machine 80,000Machine 80,000
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Decisions and Performance Decisions and Performance EvaluationEvaluation
In the real world would the manager replace In the real world would the manager replace the machine?the machine?
An important factor in replacement decisions An important factor in replacement decisions is the manager’s perceptions of whether the is the manager’s perceptions of whether the decision model is consistent with how the decision model is consistent with how the manager’s performance is judged.manager’s performance is judged.
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Decisions and Performance Decisions and Performance EvaluationEvaluation
Managers often behave consistent with their Managers often behave consistent with their short-run interests and favor the alternative short-run interests and favor the alternative that yields best performance measures in the that yields best performance measures in the short run.short run.
When conflicting decisions are generated, When conflicting decisions are generated, managers tend to favor the performance managers tend to favor the performance evaluation model.evaluation model.
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Decisions and Performance Decisions and Performance EvaluationEvaluation
Top management faces a challenge – that is, Top management faces a challenge – that is, making sure that the performance-evaluation making sure that the performance-evaluation model of subordinate managers is consistent model of subordinate managers is consistent with the decision model.with the decision model.
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End of Chapter 11End of Chapter 11