Chapter 5 Relevant Information for Special Decisions
Relevant Information • Two primary characteristics distinguish relevant from useless information: • Relevant information differs among the alternatives under consideration. • Relevant information is future oriented.
Relevant (Differential) Revenues Relevant revenues must (1) be future oriented and (2) differ for the alternatives under consideration. Since relevant revenues differ between the alternative, they are sometimes called differential revenues.
RELEVANT INFORMATION • Pass Fast, Inc. is considering two alternative locations in which to conduct its CPA review course. One alternative is an exclusive hotel; the other is a moderately priced training facility. The hotel is in a central location easily accessible to potential students. The training facility is in a less desirable location. Pass Fast has gathered the following cost data regarding the two locations.
Sunk Cost A sunk cost has been incurred in the a past transaction and cannot be changed, they are not relevant for making current decisions.
Relevancy of Opportunity Costs The sacrifice represented by a lost opportunity is an opportunity cost. Opportunity costs that are (1) future oriented and (2) differ between the alternatives are relevant for decision making, but are extremely difficult to measure. Let’s look at an example.
Opportunity Cost • You purchased a ticket to the Texas Tech – UT game this fall for $80. • Outside the game someone offers you $150. • You really want to go to the game and don’t sell your ticket • How much did it cost you to go to the game? • $150 is your opportunity cost • $80 is your sunk cost
Example • Brown Manufacturing Company is currently using a building as a manufacturing facility. Depreciation on the building is $200,000 per year. The building is in a location that is experiencing significant growth in retail shopping. A retail company has offered to rent the manufacturing facility from BMC at a price of $180,000 per year. • What information is relevant in deciding whether to move the manufacturing facility to a different location?
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 product line is eliminated. Relevant (Avoidable) Costs Unit-levelActivities Batch-levelActivities Product-levelActivities Facility-levelActivities
Cost Classification Hierarchy • Unit-level Costs • Incurred each time a company generates one unit of product • Example: Direct materials & direct labor costs • Batch-level Costs • Costs incurred for a batch of products • Example: Setup and inspection costs • Product-level Costs • Costs incurred to create, sustain, or sell a product or product line • Example: Engineering costs for new automobile model • Facility-level Costs • Incurred to support the entire company • Example: Factory depreciation; maintenance; utilities
Four Types of Special Decisions Special Order Outsourcing Segment Elimination Asset Replacement
Relevant Information and Special 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.
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. Cost per unit - $658,500 ÷ 2000 = $329.25
If the order is accepted, income will increase by $11,800. Special Order Decision A 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?
Special Order Decision If Premier can increase income by selling its printer for $250, can the company reduce its normal selling price to $250?
Special Order Decision • Quantitative Aspect 1. Determine the amount of revenue the company will earn if it accepts the special order 2. Determine the relevant costs of making the additional units 3. Compare the incremental revenues to the additional costs
What costs must be considered? • Unit-level costs • Relevant b/c cost will differ if the company makes and sells the units vs. rejecting the special order • Batch-level costs • May or may not be relevant • Relevant if must produce a separate batch to fill the order • Product-level and Facility-level costs remain unchanged = Not Relevant
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? I outsourced my homework!!
Outsourcing Decisions Let’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 1Determine the production costs Premier can avoid if itelects to outsource printer production. Cost per unit = $459,300 ÷ 2,000 = $229.65
Outsourcing Decisions Step 2Compare the avoidable production costs with the cost ofbuying the product and select the lower-cost option. COST TO BUY: $240 * 2,200 = $528,000 COST TO MAKE: $459,300 Premier should reject the outsourcing offer.
Outsourcing Decisions • Must identify the relevant costs of making a product internally and compare with cost to buy the product from an outside supplier • Make or buy decision • Relevant Costs: • Unit-level costs • Batch-level costs • Product-level costs • Facility-level costs = Not relevant
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 an a segment report for Premier Office Products that has divided its operations into three segments; (1) copiers, (2) computers, and (3) printers.
Segment Elimination Decisions • A three part decision: • Determine the amount of relevant revenue that pertains to eliminating the segment. • Determine the amount of cost that can be avoided if the segment is eliminated. • If the relevant revenue is less than the avoidable cost, eliminate the segment. If not, continue to operate it.
Segment Elimination Decisions Step 1:If Premier eliminates the copier segment, it will lose the $550,000 of revenue currently produced. If the segment continues, the revenue will be earned. Since the revenue differs between the alternatives, it is relevant.
Segment Elimination Decisions Step 2:If Premier eliminates copiers, it will avoid the following costs:
Segment Elimination Decisions Step 2:If Premier eliminates copiers, its profits will decrease: The corporate-level facility-sustaining costs will not be eliminated, but will be allocated to the remaining segments.
Assuming we eliminate the copier segment and allocate the corporate-level costs to the remaining two divisions equally, the company’s income statement will look like this.
Segment Elimination Decisions • Identify relevant costs of operating a business segment and compare with cost to revenue generated by the segment • Choice: Close-down or Continue Segment • Relevant Costs: • Unit-level costs • Batch-level costs • Product-level costs • Facility-level costs • Some Corporate-level facility costs may not be relevant
Relationships Between Avoidable Costs and Business Activity • Special order decisions affect unit-level and possibly batch-level costs. • Outsourcing can avoid many product-level as well as unit- and batch-level costs. • Segment elimination can avoid some of the facility-level costs. The more complex the decision level, the more opportunities there are to avoid costs.
Equipment Replacement Decision The equipment replacement decision should be based on profitability rather than physical deterioration. Consider the following:
Equipment Replacement Decision • 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. • The $14,000 market value of the old machine is an opportunity cost and is relevant to the replacement decision. • 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). • The $45,000 operating expenses of using the old machine can be avoided if it is replaced, to it is a relevant cost.
Equipment Replacement Decision • The cost of the new machine can be avoided by keeping the old machine, so it is a relevant cost. • The relevant cost of purchasing the new machine is $25,000 ($29,000 – $4,000). • The $22,500 of operating expenses can be avoided by keeping the old machine, so the operating expenses are relevant costs. Let’s summarize the relevant costs for the two machines.
Equipment Replacement Decision Our analysis should 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)
Asset Replacement Decisions • Identify relevant costs of operating existing assets and compare with costs of operating new, replacement assets • Company should choose the lowest cost option