Chapter Thirteen Relevant Information for Special Decisions © 2015 McGraw-Hill Education.

Chapter Thirteen

Relevant Information for

Special Decisions

© 2015 McGraw-Hill Education.

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 Cost

A 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 Costs

An 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. 13-5

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.

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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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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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?

That test was so easy. How did you

score so low?

I outsourced my homework!!

I outsourced my homework!!

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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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Qualitative Considerations1. 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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Summary of Relationships Between Decision Type and Level of Cost Hierarchy

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Equipment Replacement Decisions

The equipment replacement decision should be based on profitability rather than physical deterioration. Consider

the following:

Original cost 90,000$ Accumulated depreciation (33,000) Book value 57,000$

Market value (now) 14,000$ Salvage value (in 5 years) 2,000 Annual depreciation expenses 11,000 Operating expenses ($9,000 × 5 years) 45,000

Cost 29,000$ Salvage value (in 5 years) 4,000 Operating expenses ($4,500 × 5 years) 22,500

Old Machine

New Machine

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Equipment Replacement Decisions – Quantitative Analysis

1. 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.

2. The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement decision.

3. 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).

4. The $45,000 operating expenses of using the old machine can be avoided if it is replaced. It is a relevant cost.

1. 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.

2. The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement decision.

3. 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).

4. 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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What are the relevant costs if Premier purchases and uses the new machine?

1. The cost of the new machine can be avoided by keeping the old machine. It is a relevant cost.

2. The relevant cost of purchasing the new machine is $25,000 ($29,000 – $4,000).

3. The $22,500 of operating expenses can be avoided by keeping the old machine. The operating expenses are relevant costs.

Let’s summarize the relevant costs for the two machines.

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Equipment Replacement Decisions

Opportunity cost 14,000$ Salvage value (2,000) Operating expenses 45,000 Total 57,000$

Cost 29,000$ Salvage value (4,000) Operating expenses 22,500 Total 47,500$

Old Machine

New Machine

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 Thirteen

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